Managers of money market funds that have loaned to banks may become concerned about the solvency of those banks and attempt to withdraw their money. They can do this by not renewing the short-term loans they gave to the bank. At the same time, the money market funds’ own investors may become concerned about the money market funds themselves and rush to take their money out. Therefore, runs can occur in two ways—the money market funds can run to withdraw their funds from the banks, and the money market funds’ investors can run to withdraw their money from the funds.
A double run of this sort actually happened in the fall of 2008. Money market fund investors suddenly wanted to move their money into safer assets, such as government bonds or even just cash. This forced the money market funds to withdraw their funding from banks.

…

Within days, Reserve Primary lost some $60 billion of its $62 billion in funds, and it was closed shortly afterward.9
At the time, investors in other money market funds, even those not directly affected by the Lehman bankruptcy, treated the fates of Lehman Brothers and Reserve Primary as a signal that other investment banks and money market funds might also be at risk. To protect themselves, many investors abruptly withdrew their money. The run on money market funds was stopped only when a few days later the U.S. Treasury offered them a scheme for government-guaranteed deposit insurance.10
The run forced money market funds to reduce their investments. Many of these investments were short-term loans that the money market funds had made to banks, sometimes just for a day or a few days. The value of these short-term loans had become highly suspect after the Lehman bankruptcy.11 Reductions in money market fund lending affected not only U.S. investment banks, which were at the center of the storm, but also European banks, some of which were heavily dependent on borrowing in the money market.

…

Legally, the promise might not be binding, but when a money market fund “breaks the buck”—that is, when the value of its shares falls below $1—its “depositors” are likely to run in just the same way as the depositors of a bank. Money market funds are not explicitly insured by the deposit insurance system. Sponsoring institutions routinely provide them with backing. In the Lehman crisis, however, money market funds suffered a panic anyway until the federal government provided them with the analog of deposit insurance. Even primary money market funds take nontrivial risks in their investments without the ability to absorb losses on their own. See Acharya et al. (2010, Chapter 10), Brady et al. (2012), and Rosengren (2012). Money market funds in the United States are supervised by the SEC, as investment funds that have little to do with banking.

By noon, European stocks had tumbled, the U.S. markets were starting to dip, and the news was about to get worse. Lehman’s failure and AIG’s escalating difficulties had begun to roil money market funds. Typically, these funds invested in government or quasi-government securities, but to produce higher yields for investors they had also become big buyers of commercial paper. All morning we heard reports that nervous investors were pulling their money out and accelerating the stampede into the Treasury market. The Reserve Primary Fund, the nation’s first money market fund, had been particularly hard-hit because of substantial holdings of now-worthless Lehman paper.
Many Americans had grown accustomed to thinking that money market funds were as safe as their bank accounts. Money funds lacked deposit insurance but investors believed that they would always be able to withdraw their money on demand and get 100 percent of their principal back.

…

While we were with the president, the Reserve had announced that it would halt payment of redemptions for one week on its Primary Fund, a $63 billion money market fund that was caught with $785 million in Lehman short-term debt when the investment bank entered bankruptcy. On Monday, investors had flooded the company with requests for redemptions; by mid-afternoon Tuesday, $40 billion had been pulled. The fund had officially broken the buck, the first to do so since 1994, when the Denver-based U.S. Government Money Market Fund, which had invested heavily in adjustable-rate derivatives, fell to 96 cents.
The sense of panic was becoming more widespread. Dave McCormick and Ken Wilson came in to tell me that they had heard from their Wall Street sources that a number of Chinese banks were withdrawing large sums from the money market funds. They had also heard that the Chinese were pulling back on secured overnight lending and shortening the maturity of their holdings of Fannie and Freddie paper—all signs of their battening the hatches.

…

But most important, over the next six months I watched the yuan, which was trading at 7.43 to the dollar in December, strengthen to about 6.81 by mid-July. China’s sudden flexibility not only benefited that country but would help forestall protectionist sentiment in the U.S. Congress.
On the financial side, however, the bad news piled up day by day. In mid-November, Bank of America and Legg Mason said they would spend hundreds of millions of dollars to prop up their faltering money market funds, which had gotten burned buying debt from SIVs. Although the public considered money market funds among the safest investments, some funds had loaded up on asset-backed commercial paper in hopes of raising returns.
Meantime, the credit markets relentlessly tightened as banks grew increasingly reluctant to lend to one another. One key measure of the confidence banks had in one another, the LIBOR-OIS spread—which measures the rate they charge each other for funds—had begun to widen dramatically.

Five: The Fall
1 “TED spread”: The three-month Treasury-Eurodollar, or TED, spread measures the difference in borrowing costs on three-month Treasury bills and the cost that banks pay to borrow from each other for three months, as reflected in the London Interbank Offered Rate (LIBOR).
2 prime money market funds: There are three primary types of money market funds: Treasury and government funds that buy Treasury and agency securities; tax-exempt funds, which invest in short-term municipal securities; and prime funds, which typically pay higher rates of interest by investing in a broader range of riskier securities, including unsecured commercial paper and asset-backed commercial paper. Institutional investors use money market funds for cash-management purposes and are often more likely to move their money at the first sign of stress than individuals or retail investors. The $300 billion outflow was primarily shifted out of riskier prime funds into the other, safer types of money market funds.
3 a four-fifths stake: This equity stake was delivered to a trust that existed independently of the government and operated for the benefit of the taxpayer.

…

Meanwhile, U.S. depositors were withdrawing about $2 billion a day from WaMu, twice as much as they had withdrawn after the run on IndyMac. The “TED spread,” a measuring stick for fear in the banking system, was about to surpass the record set after the 1987 stock market crash.
Tuesday’s most chilling development outside AIG was a money market fund “breaking the buck,” which meant it could no longer promise investors 100 cents on the dollar. Money market funds were widely viewed as virtually indistinguishable from insured bank deposits, as similarly safe vehicles for storing cash with slightly better interest rates. But many money market funds had invested in commercial paper and other instruments that turned out to be riskier than they had thought. One fund, the Reserve Primary Fund, had even added to its stash of Lehman paper over the summer while everyone else was unloading it, which sparked a run on the fund after Lehman fell.

…

The legislation punted money market fund reforms to the SEC, which has so far failed to produce reforms that could prevent future runs. In 2012, after the SEC’s Mary Schapiro announced that her fellow commissioners had refused to support her reform proposals, I wrote a letter as chairman of the new Financial Stability Oversight Council proposing options for the council to pursue. “Four years after the instability of money market funds contributed to the worst financial crisis since the Great Depression, with the failure of the SEC to act, the Council should now move forward,” I wrote. Mary welcomed the letter to help her push for action at the SEC, which soon began a process to consider reforms. But more than five years after the Reserve Primary Fund broke the buck, money market funds have so far been able to block significant changes to the status quo.

Neither the funds nor federal officials considered them in any way insured by the government. But suddenly the economy was as vulnerable to a run on money market funds as it was to runs on banks.
And it wasn’t only ordinary savers who stood to get trampled. Scores of brand-name industrial companies — General Electric, Caterpillar, Dow Chemical — relied on the money market funds for their short-term borrowing, often issuing the funds IOUs called commercial paper that were backed only by the companies’ promise to pay. The Fed and the Treasury decided that to avoid a stampede out of money market funds, they had to find a way to assure consumers that the Reserve Primary Fund wouldn’t be followed by scores of other money market funds breaking the buck.
At the Fed, Don Kohn took charge of the response while Bernanke went to Capitol Hill and Warsh to New York.

…

BREAKING THE BUCK
The turmoil in the financial markets during the week of September 15 didn’t revolve only around newfangled financial instruments, cross-border sophisticated bets, or the collapse of major financial institutions. In fact, the biggest surprise of Lehman’s collapse came from money market funds, the $1-a-share mutual funds that Americans had come to consider as safe as bank accounts. Money market funds had been on the Fed list of things to worry about for months, dating back to the fragility of the tri-party repo market and the Bear Stearns episode. But with so much advance speculation about Lehman’s frailties, it didn’t occur to Bernanke, Geithner, or Paulson — or any of their staff — that a major money market fund would hold a significant chunk of Lehman’s short-term debt. But the Reserve Primary Fund, the oldest of all the money market mutual funds, had 1.2 percent of its $63 billion in Lehman — holdings that would prove devastating and which couldn’t wait for Congress to act.

…

At the Treasury, the job fell to David Nason, the assistant secretary for financial institutions. Nason recently had recused himself to look for a job. After AIG imploded, he dropped the job hunt and returned to work.
In the frantic search for a solution, talk bubbled up about the Fed lending directly to the money market funds. It turned out SEC rules forbid the funds from borrowing. There was talk about asking the Federal Deposit Insurance Corporation to insure the money market fund deposits; that went nowhere. There was talk about allowing industrial companies to come directly to the Fed for loans, an idea that resurfaced a few weeks later. The money market fund industry itself was split on the question of government aid. The biggest funds thought they could protect themselves and the $1-a-share value and didn’t want to pay for government insurance or invite politicians into their business.

But then business depositors took to practicing "sweeps" —moving the money in their bank accounts into investment funds until they needed it to pay bills, at which point they moved it back. And money market funds arose to provide people with checkable accounts, just like bank accounts (though uninsured) —except that they paid interest. Banks responded by supplementing deposits as a source of bank capital with loans from other sources, on which they had to pay interest— and hence had to lend their capital out at a higher interest rate than they were paying for the capital furnished by their depositors. This required them to make riskier loans. The deregulatory strategy of allowing nonbank financial intermediaries to provide services virtually indistinguishable from those of banks, such as the interest-bearing checkable accounts offered by money market funds, led inexorably to a complementary deregulatory strategy of freeing banks from the restrictions that handicapped them in competing with unregulated (or very lightly regulated) financial intermediaries — nonbank banks, in effect.

…

Lehman defaulted on some $165 billion in unsecured debt, but that was the least of the problem. It was the number-one dealer in commercial paper, a form of debt that seemed safe because of who the issuers were (large, blue-ribbon corporations) and because it was short term. The major customers for commercial paper were money market funds, which pay low interest rates because they are (or rather were) considered utterly safe. Lehman was the middleman between the issuers of commercial paper and the money market funds, and when it unexpectedly collapsed, the commercial-paper market—a significant part of the overall credit market—froze. Lehman's collapse showed that commercial paper wasn't so safe after all, so money markets stopped buying it and as a result issuers of commercial paper stopped issuing it. They had standby lines of credit at banks, however, and when all at once they tried to draw on them this further reduced the banks' ability to make new loans.

…

Bank capital would consist mainly of zero-interest demand deposits and federal securities and would be used mainly to make short-term commercial loans. But we know that this model of banking would not be viable if other financial intermediaries were permitted, as they are today, to offer close substitutes for bank products. Does this mean, however, that money market funds, hedge funds, and all the other nonbank banks must be placed under the same regulatory controls as commercial banks? Should they for example be required to have reserves? To pay zero interest to the lenders of their capital? If the answer to these questions is yes, that is the end of hedge funds, of money market funds, etc. If the answer is no, it is unclear how much reregulation of commercial banks is possible. If there is another answer, it will take much thought to work out.
There is a further and very serious complication. As far as I know, no one has a clear sense of the social value of our deregulated financial industry, with its free-wheeling banks and hedge funds and private equity funds and all the rest.

But by the end of Tuesday, with Lehman debt now priced at zero cents on the dollar, they concluded they could not, and announced that Reserve’s shares were now priced at 97 cents instead of one dollar.
Federal Reserve and Treasury officials had spent the weekend trying to imagine and prepare for every collateral effect of a Lehman bankruptcy. One thing they apparently did not consider was that a money market fund might break the buck. That announcement arguably sowed as much panic as Lehman’s bankruptcy itself.
Within a week, investors yanked a total of $349 billion from almost every money market fund not invested solely in Treasury bills, regardless of whether it had exposure to Lehman. Some thirty-six of the one hundred largest U.S. prime money market funds were eventually supported. Meanwhile, the funds themselves stopped buying commercial paper, the short-term IOUs that everyone from General Electric to obscure investment funds had come to rely on to fund everything from equipment inventory to subprime mortgage-backed securities.

…

It later emerged that, between 1972 and the lead-up to the crisis, there had been 146 instances of a fund sponsor intervening to preserve the dollar per share value of a money market fund. As I mentioned earlier, only once had a fund actually broken the buck and been forced to liquidate. The sponsors in these cases were doing the right thing for themselves and their investors, but in the grand scheme of things, these backstage interventions worsened the eventual crisis, because they reinforced the illusion that investors would never lose money in money market funds.
Over the course of the next five years, other institutions would suffer the same fate as money market funds: the illusion of safety would be abruptly torn away from European government debt during the euro crisis, as we will see in Chapter 5, and the same thing very nearly happened to U.S.

…

The failure of Lehman shattered assumptions about the safety of all the major financial institutions. If Lehman wasn’t too big to fail, nobody was: not Goldman Sachs, Morgan Stanley, Citigroup, or any other institution.
The second assumption that had been allowed to take root was that money market funds were basically the same as bank deposits. That, more or less, was how their shareholders treated them. Rate of return was much less important than safety and immediate access to funds. “We could get our cash any day that we would need it,” explained one investor in Reserve. “And it gave us safety because the money market fund was a dollar in, you get your dollar out.”
Of course, these investments weren’t bank deposits. Funds were not legally obligated to maintain the dollar per share value. But in practice, the reputational damage of breaking the buck was so great that sponsors—the management companies who ran the funds—almost always put their own capital in rather than allow it to happen.

Although Deutsche denies Linares’s involvement, the lure of the financial iPhone caught the attention of Justo Palma, a fund manager for a mutual fund company called BZ Gestion in the city of Saragossa, northeast of Madrid, in 2001.9 Palma invited several banks to propose a structured product for one of BZ Gestion’s money market funds, and Deutsche Bank won the tender, selling a REPON-style product containing a single slice of a synthetic CDO.
Unfortunately, a money market fund is not the same as an insurance company, which holds its assets at book value. Palma’s purchase was marked to market once a month, and as the provider of the product, Deutsche was obliged to provide its valuation. This quickly exposed a significant difference between the price Palma had paid and what the CDO was worth, even without any defaults in the portfolio.

…

Big corporate borrowers wanted to reduce the cost of bank loans, and the newly invented commercial paper or IOU market was a great way of doing that. Money market mutual funds sprang up to give shortchanged bank depositors a better deal. Like Smith, these money market funds bought commercial paper because the extra returns gave them an edge over traditional bank deposits. Over time, the money funds started investing in short-term repo agreements as well, helping to prop up the growing balance sheets of investment banks like Goldman Sachs and Lehman Brothers.
Looking at this upstart market, the traditional lending banks could argue that if their depositors took those green spectacles off, Uncle Sam would be there to protect them in the form of the FDIC’s guarantee, which stood at $100,000 per customer in 2007. Money market funds responded that they didn’t need this protection because they weren’t “borrowing short and lending long,” as banks did—IOUs and repos were only short-term investments, not long-term loans.

…

Partridge-Hicks and Sossidis soon realized that a ready-made solution was the army of depositors that had already been assembled by U.S. money market funds, and other institutions looking for places to park their cash. If their new bank could sell IOUs to these funds, then it would have, in effect, outsourced its deposit taking to the likes of Schwab or Fidelity.
With this final spark of inspiration, Partridge-Hicks and Sossidis were ready, and in September 1988, the world’s first shadow bank, Alpha, began operations. An up-and-coming Moody’s analyst, Raymond McDaniel, worked with the Citibank duo to ensure that Alpha achieved the top “A-1+/P-1” commercial paper rating for its IOUs. Another shadow bank, Beta, followed a year later.
In the same way that money market funds were not officially deposit-taking banks, Alpha and Beta were not officially banks.

The current T-bill rate is a good proxy for
the interest an investor will earn in a money market fund because
T-bills are frequently purchased in money market funds.
Understanding Investment Risk
27
T-bills are often called a “risk-free” investment in the financial
world because of their short maturity and government guaranteed
return. However, risk-free may be an inappropriate choice of words.
T-bills do have a reliable positive return; however, that return is
subject to the corrosive effects of taxes and inflation.
Figure 2-1 highlights the year-over-year T-bill return minus
25 percent income tax and the inflation rate. There have been many
years when the rate of return on T-bills has not kept pace with the
inflation rate after taxes. Investors in T-bills and money market
funds are losing purchasing power in the years when the bar in
Figure 2-1 is below 0 percent.

…

FIGURE
1-1
The Investment Pyramid
Discretionary speculative
(commodities, individual stocks)
5
Nondiscretionary assets
(restricted stock, pension, Social Security)
4
Discretionary long-term illiquid assets
(home, properties, businesses, collectibles)
3
Discretionary long-term liquid investments
(mutual funds, ETFs, CDs, bonds, annuities)
2
1
Cash accounts for living expenses and emergencies
(checking account, savings account, money
market fund)
CHAPTER 1
10
Here are brief descriptions of the five levels:
1. Level one is the base of the pyramid. It is characterized
by highly liquid cash and cash types of investments that
are used for living expenses and emergencies. This
money is typically in checking accounts, savings
accounts, and money market funds. This cash is not part
of your long-term investment allocation, and you should
not be overly concerned that your rate of return is low.
The amount to keep in cash varies with your
circumstances. I recommend 3 to 4 months in cash if you
are single, 6 to 12 months in cash if you have a family,
and 24 months when you retire.
2.

…

Younger investors will develop asset allocations
from a perspective that’s different from that of older investors
because they are different, but that does not mean that young
investors will have a more aggressive allocation than older people.
It depends on each person’s unique situation. Asset allocation is
personal. There is an appropriate allocation for your needs at every
stage in life. Your mission is to find it.
HOW ASSET ALLOCATION WORKS
Asset classes are broad categories of investments, such as stocks,
bonds, real estate, commodities, and money market funds. Each
asset class can be further divided into categories. For example,
Planning for Investment Success
19
stocks can be categorized into U.S. stocks and foreign stocks. Bonds
can be categorized into taxable bonds and tax-free bonds. Real
estate investments can be divided into owner-occupied residential
real estate, rental residential real estate, and commercial properties.
The subcategories can be further divided into investment
styles and sectors.

Some brokerages will put your cash into a money market fund automatically, even if you don’t ask for that. Others will give you the option to automatically sweep your cash into a money market fund. Some only make that option available for people with large accounts. Even if you can’t sweep all of your balances into a money market account, you can move money into a money market fund just like you move money into a mutual fund that invests in stocks or bonds.
Because of the low returns on money market mutual funds, you want to be sure to avoid any transaction fees at all (unless you have lots and lots of money invested). Today, a $1,000 investment in a money market fund might only earn $10 in a year. If you have to pay $10 to get in and $10 to get out of a money market fund, you’ll lose ten dollars. You’d be better off to have your cash sit idle for a year earning nothing.

…

Over time, this should have the effect of reducing the percentage of your portfolio invested in other assets. In this way, you never need to sell assets just to shift your allocation.
Thoughtful adjustments to your asset allocation will better prepare you for retirement.
What Is A Money Market Fund And How Do I Use One?
Learning about money market funds and how to use them in your investing programs can help you make better investment decisions, both protecting your assets and allowing you to earn more in the long run.
A money market mutual fund (bit.ly/Z1uvGU) is a mutual fund that invests in assets that are so stable that the fund maintains a constant price of $1 per share. Money market funds are not FDIC insured (though some banks have offered savings accounts or even checking accounts with the name “money market” but they are FDIC insured and are not mutual funds).
The money market refers to the instruments the fund invests in.

…

The money market refers to the instruments the fund invests in. The investments include mostly the sorts of instruments that consumers and small investors don’t normally buy directly. These include short term treasury obligations (T-bills) and commercial paper (short term corporate obligations). Everything in the portfolio of a money market fund would be expected to mature within a few months. The cash is then reinvested.
Money market funds earn low returns but are generally considered safe despite their lack of a formal guaranty. The industry is carefully regulated and investor losses in this space have been tiny. You can reasonably expect to get your money back with interest.
Most investors look at three primary types of assets for their long term investments. Stocks, bonds and cash.

The rapid move upward in LIBOR came in reaction to new SEC regulations that went into effect in October 2016 in the money-market fund industry, as well as to other changes in how banks are regulated that were expected to take effect in December 2016 and January 2017. Banks are starting to charge each other much more for short-term loans, which is an ominous sign, and stands in stark contrast to the new highs being achieved in the stock market and the rally in Treasury securities (before it sold off dramatically in the wake of Trump’s unexpected victory).
The SEC’s new rules for money-market funds require that they represent to investors that the funds are “money good,” or worth what they say they are worth. The problem being addressed by the SEC, at the instigation of the Federal Reserve, occurred in September 2008 when the Reserve Fund, a money-market fund—which is supposed to be as safe as a savings account—“broke the buck,” meaning that $1 invested in the fund, which was supposed to always be worth $1, was no longer worth $1.

…

But more important to the confidence of the financial system was the fact that because of the turmoil in the markets, a money-market fund was no longer considered prudent. The reason the Reserve Fund “broke the buck” is that it didn’t just keep the money investors gave it in cash; it invested the money, in an effort to give investors a slightly higher yield, or financial return on the money invested, than could be found in a savings account. The Reserve Fund generated those slightly higher returns by investing in something that seemed to be rated AAA—the AAA tranches of securitizations, the funky and creative securities created by Lew Ranieri—that turned out not to be really AAA after all (as we all know). Understandably, the Federal Reserve doesn’t want that to happen again, hence the new rules about money-market funds that took effect last year. The problem, as usual, is not the honorable goal of trying to prevent a money-market fund from ever again breaking the buck; the problem is the unintended consequences of trying to make sure that doesn’t happen.

…

Better-capitalized firms, he continued, tended “to hoard” their financial resources “in light of their uncertainty as to whether their balance sheets might come under greater stress and their reluctance to catch the proverbial falling knife by purchasing assets whose prices were plummeting with no obvious floor.”
Tarullo’s postcrisis effort to “protect financial stability” remains focused on regulating “runnable securities.” Hence his mandate that money-market funds, in which millions of Americans park billions of their dollars believing them to be safe and secured, could no longer invest in the AAA tranche of securitizations. In Tarullo’s world, they were no longer considered “safe” investments. Preventing money-market funds from investing in the top tranche of securitizations will definitely make them safer, especially as the funds replace these purchases with those of genuinely safer Treasury securities. The unintended consequence of Tarullo’s decision, though, is to stick a dagger in the heart of the securitization market because a key buyer of the top tranche of the securities has been regulated away and without that buyer, the market fades.

Citi itself had created seven shadow banks, and by 2007 these held almost $100 billion of assets. The SIVs were also entwined with America’s vast $3 trillion money-market fund sector. Most ordinary Americans assumed that money-market funds were as safe as bank deposits. The funds marketed themselves on the mantra that no fund had ever “broken the buck,” or returned less than 100 percent of money invested. However, these money-market funds were now holding large quantities of notes issued by SIVs and were not covered by any federal safety insurance. That created the potential for a chain reaction; if SIVs collapsed, the worry went, money-market funds would suffer losses and consumers would then suddenly discover that their supersafe investments were not so safe after all.
Citi hoped to avoid a panic by persuading American banks to act, en masse, to avert widespread SIV collapse.

…

Another unexpected shock hit the $3 trillion American money-market fund sector. In the months before the Lehman collapse, many of these funds had purchased debt issued by Lehman Brothers, assuming that the US government would never let Lehman collapse. Now those funds were nursing substantial losses. On September 16, the $62 billion Reserve Primary Fund, the country’s oldest money-market fund, posted a somber statement on its website: “The value of the debt securities issued by Lehman Brothers Holdings (face value $785 million) and held by the Primary Fund has been valued at zero effective as of 4:00 p.m. New York time today.” That threatened to spark more panic. America’s money-market fund industry had prided itself on never “breaking the buck,” and the Reserve had just done so. A run on the money-market funds now seemed likely.

…

Corporate treasurers often bought commercial paper, since those notes tended to produce a return a fraction better than anything found in a bank account. Pension funds sometimes bought commercial paper, too. One of the biggest sources of demand for commercial paper, though, came from the giant $3 trillion money-market fund sector.
These funds typically raised money from ordinary retail investors or companies, which tended to treat money-market funds as similar to a bank account: they placed cash there assuming they could always withdraw it, and on short notice. Precisely because money-market funds knew that investors might redeem their cash with little notice, such funds usually wanted to purchase only assets that had a short duration and were safe. Commercial paper fit the bill perfectly.
The specific corner of the market where IKB raised funds was one subset of this world, a mutation known as the asset-backed commercial paper (ABCP) sphere.

The financial crisis in the fall of 2008 had an added complication because banks were funding themselves with very short-term financing instruments that weren’t deposits. Much of this short-term financing was being provided by money-market funds, which were not explicitly guaranteed by the Federal Reserve or the FDIC. When investors began running from money-market funds in September 2008, the Treasury Department stepped in to guarantee these funds. Their blanket guarantee immediately calmed the market, which shows that the government can and should prevent runs in the financial sector. We view these policies as advisable and fitting within the appropriate role of the government and central bank in preventing crippling bank runs.
Preventing runs requires lending by the Federal Reserve, and in the case of money-market funds during the fall of 2008, it even required lending by the U.S. Treasury. However, this kind of support should not be viewed as a bailout.

…

We readily admit that there is substantial evidence that investors show an extreme desire to hold what appear to be super-safe assets. But this is likely driven by the same government subsidies to debt financing we have already mentioned. For example, when the financial crisis peaked in September 2008, the U.S. Treasury stepped in to guarantee money-market funds. Now all investors know that money-market funds enjoy an implicit guarantee from the government. Their “desire” to put cash into a money-market fund is not some primitive preference. They are simply responding to a government subsidy.
Also, even if investors do exhibit innate preferences for super-safe assets, the government should directly cater to the demand, not the private sector. The closest thing most economies have to a truly super-safe asset is government debt.

…

First, they had a lot less debt coming into the recession. The richest 20 percent of home owners had a leverage ratio of only 7 percent, compared to the 80 percent leverage ratio of the poorest home owners. Second, their net worth was overwhelmingly concentrated in non-housing assets. While the poor had $4 of home equity for every $1 of other assets, the rich were exactly the opposite, with $1 of home equity for every $4 of other assets, like money-market funds, stocks, and bonds. Figure 2.1 shows these facts graphically. It splits home owners in the United States in 2007 into five quintiles based on net worth, with the poorest households on the left side of the graph and the richest on the right. The figure illustrates the fraction of total assets each of the five quintiles had in debt, home equity, and financial wealth. As we move to the right of the graph, we can see how leverage declines and financial wealth increases.

The commercial paper got a top rating from the rating agencies, making it possible for money market funds to buy it. However, in order to obtain that all-important top rating, the sponsoring bank, or another bank, invariably had to provide some kind of guarantee, in the event that the vehicle found itself unable to replace the commercial paper when it came due.
As the market got crazier, money market funds became more and more enamored of this paper; they, too, were competing for that extra little bit of yield. Although money market funds were serving the role of the old-fashioned bank—they were ultimately the real lender—they weren’t regulated the way banks were. Since they were holding highly rated securities—as SEC rules required them to do—no one in the government was concerned with the quality of the collateral.
But what would happen if the money market funds all started questioning the quality of the assets backing their paper at the same time?

…

For the Bear guys, this was indeed a savvy way to get low-cost, low-risk leverage; among other things, lenders couldn’t simply yank cash from the funds, the way repo lenders could. But the risk was still there—in this case, it resided at the bank that underwrote the CDO. That’s because instead of selling long-dated debt, the new CDOs sold very short-term, low-cost commercial paper. This paper, in turn, was bought by money market funds around the country. In order to make the commercial paper palatable for money market funds, the bank that underwrote the CDO—often Citigroup and, later, Bank of America—would issue what was called a liquidity put. That meant that if buyers for paper became scarce—in the event, say, of a disruption in the market—the banks would step in and buy it themselves. Cioffi raised as much as $10 billion this way, according to BusinessWeek, while Citigroup earned $22.3 million in fees for underwriting the CDOs and was paid another $40 million a year for providing the liquidity put.

…

This worry was exacerbated by the fact that the main provider of mortgages, the savings and loan, or thrift, industry, was in terrible straits. The thrifts financed their loans by offering depositors savings accounts, which paid an interest rate set by law at 5¾ percent. Yet because the late 1970s was also a time of high inflation and double-digit interest rates, customers were moving their money out of S&Ls and into new vehicles like money market funds, which paid much higher interest. “The thrifts were becoming destabilized,” Ranieri would later recall. “The funding mechanism was broken.”
Besides, the mortgage market was highly inefficient. In certain areas of the country, at certain times, there might be a shortage of funds. In other places and other times, there might be a surplus. There was no mechanism for tapping into a broader pool of funds.

And they certainly have no reason to run on the Second National Bank next door. Not so with money funds. Shareholders in the Reserve Primary Fund did lose money, even if only 3 percent. They, therefore, did have a reason to run on the Reserve. And the resulting fears of losses at other money market funds quickly led to runs elsewhere.
This was serious business. Within days, “it was overwhelmingly clear that we were staring into the abyss—that there wasn’t a bottom to this—as the outflows [from money funds] picked up steam on Wednesday and Thursday.” In just a week, investors withdrew about $350 billion from prime money market funds. That meant, of course, that fund managers had to liquidate an equal volume of commercial paper, T-bills, and so on in order to meet redemption calls. But after the Lehman-induced losses at the Reserve, no fund manager wanted to buy CP—and not just Lehman’s CP, anyone’s.

…

But the episode didn’t instill confidence in the United States Treasury.
The Fed pitched in, too, by establishing the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility. (AMLF, if you must know. And try saying the full title fast.) The AMLF was created to extend nonrecourse loans at low interest rates to banks willing to purchase high-quality asset-backed commercial paper from money market funds—who needed to sell it desperately because they were experiencing runs. Let’s dwell on the awkward word nonrecourse for a moment, because it’s important and this is not the last time you’ll see it.
“Nonrecourse” means that if the assets in question (in this case, commercial paper) default, the lender (in this case, the Federal Reserve) can claim back only the collateral on the loans. It cannot go after any other assets owned by the borrowers—who, in the case of the AMLF, were banks.

…

Furthermore, it was not until January 30, 2009, that the Fed got around to announcing the detailed rules governing the AMLF. Yes, it was another case of “leap before you look.” But together, the Treasury’s modified money market guarantee program and the Fed’s AMLF successfully ended the run on the money funds. On February 1, 2010, the Fed shut the facility down, netting a small profit on the operation. The balances had long since dwindled to zero, anyway.
But the battles to save the money market funds and the commercial paper markets did not end on September 22. On October 7, with the financial panic in full swing, the Board again invoked Section 13(3) to justify creation of the Commercial Paper Funding Facility (CPFF) to, in the Fed’s words, “provide a liquidity backstop to U.S. issuers of commercial paper.” Let’s parse those words carefully, because the CPFF proved to be a turning point:
A “liquidity backstop”?

Its commercial paper now became worthless, causing problems for all those who had bought it expecting to get their money back soon. At about the same time as the family with children at Esperanto were served their tarred pigeon with pastella classique and almond, a money-market fund of great renown yet obscure to the general public, the Reserve Primary Fund, posted a message on its website:
The value of the debt securities issued by Lehman Brothers Holdings, Inc. (face value $785 million) and held by the Primary Fund has been valued at zero effective as of 4:00PM New York time today. As a result, the NAV [net asset value] of the Primary Fund, effective as of 4:00PM, is $0.97 per share 2
This message may not sound very dramatic, because money-market funds are not-or are at least not supposed to be-dramatic. Investing in such a fund is a way of lending short term to a diversified group of stable institutions, such as governments, banks, and large corporations.

…

Investing in such a fund is a way of lending short term to a diversified group of stable institutions, such as governments, banks, and large corporations. Most people see investing in them as a more profitable version of keeping their money under their mattress. In almost 40 years of history, hardly any money-market fund had ever lost money. Now that the Primary Fund's loss on Lehman paper had caused its funds to drop in value from $1.00 to $0.97, it had happened again-but on a huge scale. The upshot was a mass flight from money-market funds, on which many institutions were dependent for their financing, not least the special companies that the banks had crammed full of mortgage-backed securities and put outside their balance sheets.
The message posted on the Reserve Primary Fund's website was tantamount to crying "Fire!" in a crowded theater. Panicking investors trampled one another as they tried desperately to get to the exits.

…

They finally concluded that it should work, there would be no systemic crisis, it was not the end of the world.
And there would have been no systemic crisis had it not been for that money-market fund announcing a loss while the family with children was being served their pigeon at the Stockholm restaurant. The money markets, which had seemed unsafe as far back as August 2007 because of mortgage-backed securities, now came across as downright lethal. By that Wednesday night, institutional investors had withdrawn almost $150 billion from them, more than one-twentieth of their total value. Panic-stricken money-market funds were selling commercial paper to be able to give investors their money back. On Thursday, Putnam Investments had to liquidate a $15 billion fund to cope with the pressure for repayments.

Companies that issue junk bonds promise to pay higher yields in order to attract buyers who otherwise might purchase safer bonds.
Load fund: A mutual fund that levies a sales charge.
Long-term capital gain: Profit on the sale of a security held at least one year that generally results in lower tax.
Market timing: Attempting to forecast market direction and then investing based on the forecasts.
Money market fund: A mutual fund that invests in very-short-term securities. Money market funds attempt to maintain a constant $1 net asset value (NAV).
Mortgage-backed securities: Bond-type securities representing an interest in a pool of mortgages.
Municipal bond fund: A mutual fund that invests in tax-exempt bonds. These funds are best suited for higher-income taxpayers in taxable accounts.
Nominal return: The return on an investment before adjustment for inflation.

…

It's not how much you make, its how much you keep.
The measure of wealth is net worth: the total dollar amount of the assets you own minus the sum of your debts. So, the first thing we want you to do is calculate your net worth. Calculating your net worth is very simple. First, add up the current dollar value of everything you own. Such items include the following:
• Cash in checking and savings accounts, credit unions, or money market funds
The cash value of your life insurance
• Your home and any other real estate holdings
• Any stocks, bonds, mutual funds, certificates of deposit, government securities, or other investments
• Pension or retirement plans
• Cars, boats, motorcycles, or other vehicles
• Personal items such as clothing, jewelry, home furnishings, and appliances
• Collectibles such as art or antiques
• Your business, if you own one and were to sell it
• Anything else of value that you own
Once you have the total current value of what you own, add up the total amount of all debts that you currently owe.

…

As an investor in a mutual fund, you actually own a small fractional interest in the underlying pool of securities purchased by the managers of your mutual fund.
Mutual funds are governed by the Investment Company Act of 1940, and in most cases by the states where they do business.
Mutual funds are available in many varieties. There are equity mutual funds that invest in stocks, bond funds that invest in (you guessed it!) bonds, and funds that invest in a combination of both stocks and bonds (hybrid or balanced funds). There are also money market funds, whose goal is to offer a stable $1 per share value.
Within each type of mutual fund (equity fund, bond fund), there are a number of funds with differing investment objectives. For instance, equity mutual funds include these funds:
Aggressive growth funds
• Growth funds
• Growth and income funds
• International funds
Sector and specialty funds (such as REITs (Real Estate Investment Trusts) and health care)
Just as with equity mutual funds, bond fund investors have a wide range of bond mutual funds to choose from.

Issued and guaranteed by the U.S. government, T-bills are auctioned with maturities of four weeks, three months, six months, or one year. They are sold at a minimum $1,000 face value and in $1,000 increments above that. T-bills offer an advantage over money-market funds and bank CDs in that their income is exempt from state and local taxes. In addition, T-bill yields are often higher than those of money-market funds. For information on purchasing T-bills directly, go to www.treasurydirect.gov.
Tax-Exempt Money-Market Funds
If you find yourself lucky enough to be in the highest federal tax bracket, you will find tax-exempt money-market funds to be the best vehicle for your reserve funds. These funds invest in a portfolio of short-term issues of state and local government entities and generate income that is exempt from both federal and state taxes if the fund confines its investments to securities issued by entities within the state.

…

Addresses and phone numbers are given for each listing, and you can call to confirm that the deposits are insured and learn what current rates of return are being offered.
Internet Banks
Investors comfortable with the wide world of the Web might wish to take advantage of online financial institutions that reduce their expenses by having neither branches nor tellers and by conducting all their business electronically. Thanks to their low overhead, they can offer rates significantly above both typical savings accounts and money-market funds. And, unlike money-market funds, those Internet banks that are members of the Federal Deposit Insurance Corporation can guarantee the safety of your funds. To find an Internet bank, go to the Google search engine and type in “Internet bank.” You will also see many of them popping up when you do a rate search on www.bankrate.com for the banks with the highest yields. The Internet banks generally post the highest CD rates available in the market.

…

Remember also that you may want to alter the percentages somewhat depending on your personal capacity for and attitude toward risk. Those willing to accept somewhat more risk in the hope of greater reward could cut back on the proportion in bonds. Those who need a steady income for living expenses could increase their holdings of real estate equities, because they provide somewhat larger current income.
A SPECIFIC INDEX-FUND PORTFOLIO FOR AGING BABY BOOMERS
Cash (5%)*
Fidelity Money Market Fund (FORXX), or Vanguard Prime Money Market Fund (VMMXX)
Bonds (27½%)†
Vanguard Total Bond Market Index Fund (VBMFX)
Real Estate Equities (12½%)
Vanguard REIT Index Fund (VGSIX)
Stocks (55%)
U.S. Stocks (27%)
Fidelity Spartan (FSTMX), T. Rowe Price (POMIX), or Vanguard (VTSMX) Total Stock Market Index Fund
Developed International Markets (14%)
Fidelity Spartan (VSIIX), or Vanguard (VDMIX) International Index Fund
Emerging International Markets (14%)
Vanguard Emerging Markets Index Fund (VEIEX)
Remember also that I am assuming here that you hold most, if not all, of your securities in tax-advantaged retirement plans.

pages: 479words: 113,510

Fed Up: An Insider's Take on Why the Federal Reserve Is Bad for America
by
Danielle Dimartino Booth

“I don’t think they thought this God-damned thing through, to figure out what the ripple effects would be.”
Lehman’s demise triggered a tsunami that swept the globe in waves.
“Lehman Brothers begat the Reserve collapse, which begat the money-market run, so the money-market funds wouldn’t buy commercial paper,” a Treasury official told the New Yorker. “The commercial-paper market was on the brink of destruction. At this point, the banking system stops functioning. You’re pulling four trillion [dollars] out of the private sector [money-market funds] and giving it to the government in the form of T-bills. That was commercial paper funding GE, Citigroup, FedEx, all the commercial-paper issues. This was systemic risk. Suddenly, you have a global bank holiday.”
At this juncture, I was producing not one but two briefings a day for Fisher.

…

Why was Yellen so insistent? Concurrent with the rate hike, the Fed quietly lifted the cap on a recently created lending facility to $2 trillion, insuring that in case of future disruption, the Fed’s balance sheet would act as a backstop to the financial system.
Yellen had to hike the rate into positive territory to engage that lending option, which requires money market fund participation. With interest rates at the zero bound, money market funds have been operating in the red for years.
As her fame has grown, Janet Yellen is recognized in restaurants and airports around the world. But her world has narrowed. Because the Fed chairman can so easily move markets with a few casual words, Yellen can’t get together regularly and shoot the breeze with businesspeople or analysts who follow the Fed for a living.

…

Japan had been wallowing in a zero-interest-rate environment for years. By following its lead, the Fed risked fostering zombie corporations and banks.
“I have worked and lived in Japan and we have learned from what they’ve done,” Fisher said. “But the fact is that we have no sustained experience in the modern era in the United States with T-bill rates and the effective fed funds rate trading near zero. We do know that money market funds will become unprofitable if rates get much lower. Let me just say to those who sort of dismiss that”—meaning Yellen—“I think we might look a little foolish if we drove some of them out of business, especially after creating two special facilities to support their continued intermediation functions on the basis that they were critically needed for their roles in the commercial paper market.”

Investors benefit from taking the broadest view of their financial circumstances.
Financial and nonfinancial liabilities further influence portfolio decisions. Home mortgages and personal loans comprise the largest components of most individual financial liabilities. From a portfolio perspective, liabilities act like negative assets. In other words, borrowing by an individual offsets lending (ownership of bond or money-market funds) by that individual. In fact, wealth-maximizing individuals compare the after-tax costs of debt with the after-tax returns from bonds, liquidating bond positions to pay off loans when the costs of debt exceed the returns from bonds. Rational investors consider liability positions when making asset allocations.
Truly extraordinary expertise deserves consideration in portfolio decision making.

…

To accommodate multiple goals, investors specify a hoped-for schedule of future financial flows, thereby defining the relevant investment horizon. By aggregating various needs and desires, a full picture of the investor’s time horizon emerges.
The appropriate degree of investment risk depends on the time available until funds are needed. For periods of one to two years or less, investors ought to favor bank deposits, money-market funds or short-term bond funds. By avoiding material credit risk and searching for low management expenses, investors solve the simple problem of short-term investing.
For terms of eight to ten years or more, investors face much more interesting, more daunting, and potentially more rewarding investment alternatives. An equity-oriented, diversified asset allocation provides the most likely framework for longer-term success.

.* On Tuesday, with the collateral damage caused by Lehman’s failure beginning to spread, the Fed stepped in with an $85 billion credit line to keep AIG afloat, fearing that if the insurer defaulted on its hundreds of billions of dollars in credit default swaps, its counterparties would suffer devastating losses—or, at the least, fear of those losses would cause the financial markets to grind to a halt.
Also on Tuesday, the Reserve Primary Fund, one of the largest money market funds, announced that it would “break the buck”; because of losses on Lehman debt, it could not return one dollar for each dollar put in by investors. As a result, money flooded out of money market funds, forcing Treasury to create a new program to provide insurance for those funds. The flight from money market funds dried up demand for the commercial paper used by corporations to manage their cash, raising the specter that major corporations might not be able to make payroll. This forced the Fed to establish a program to buy commercial paper from issuing corporations—in effect lending money not just to banks, but directly to nonfinancial companies.

…

Traditionally, households and businesses would put their excess cash in deposit accounts at commercial banks or S&Ls, which would lend the cash out as mortgages and commercial loans. However, the high interest rates of the 1970s convinced investors to move their savings from bank accounts to money market funds, which invested in short-term bonds and commercial paper. Increasing affluence also fed the growth of mutual funds and pension funds, which sought out higher-yield investments. This demand for yield created the opportunity for investment banks to raise money for corporate clients by issuing commercial pa-per and bonds and selling them directly to large institutional inves-tors. Money still flowed from households to corporations, but instead of passing through commercial banks, now it could pass through a money market fund or mutual fund—with a helping hand from Wall Street.
Mortgage-backed securities had a similar effect. Institutional investors bought mortgage-backed securities created by investment banks; the cash flowed to mortgage lenders, who no longer needed to be affiliated with traditional banks, because they did not rely on deposits for funding.

…

Certain financial institutions are so big, or so interconnected, or otherwise so important to the financial system that they cannot be allowed to go into an uncontrolled bankruptcy; defaulting on their obligations will create significant losses for other financial institutions, at a minimum sowing chaos in the markets and potentially triggering a domino effect that causes the entire system to come crashing down. The bankruptcy of Lehman Brothers in September 2008 accelerated the collapse of American International Group, forcing it into the arms of the Federal Reserve; Lehman’s failure also forced the Reserve Primary Fund to “break the buck,” causing a sudden loss of confidence in all money market funds; in turn the flood of money out of money market funds caused the commercial paper market to freeze, endangering the ability of many corporations to operate on a day-to-day basis. The failure of Lehman also caused large cash outflows from the remaining stand-alone investment banks, Goldman Sachs and Morgan Stanley. The sequence of falling dominoes was only stopped by massive government rescue measures, and the panic that occurred despite the government’s intervention helped transform a mild recession into the most severe recession of the postwar period.

Today, following years of generous interest rates and the introduction of municipal bond funds in the late 1970s, combined assets of tax-free and taxable bond funds total $3 trillion, 25 percent of the fund industry’s total assets.
As the dominance of equity funds waned, money market funds, the fund industry’s great innovation of the mid-1970s, quickly became the industry’s most powerful engine of growth. In 1984, money fund assets of $235 billion were three times equity fund assets. Their growth didn’t let up until 2008, when money fund assets reached $3.8 trillion. With the failure of a giant money fund in 2008, followed by challenges to the money fund structure by federal regulators, assets retreated to $2.6 trillion, now 21 percent of the mutual fund industry total. With the rise of bond funds and money market funds, nearly all of the large fund managers—which for a half-century had primarily operated as professional investment managers of a single equity fund or a handful of equity funds—became business managers offering a wide range of investment options, financial department stores that focused heavily on administration and marketing.

…

(Only about 50—all equity funds—were large enough to have their returns reported in the annual Wiesenberger Investment Companies manual, issued each year from 1938 until 1995.) Today, the total number of equity funds comes to a staggering 5,091. Add to that another 2,262 bond funds and 595 money market funds, and there now are 7,948 traditional mutual funds, plus another 1,446 exchange-traded index funds. It remains to be seen whether this huge increase in investment options—ranging from the simple and prudent to the complex and absurd—will serve the interest of fund investors. I have my doubts, and so far the facts seem to back me up. The good news is that many of the new funds were bond funds and money market funds, which for decades have provided generous premium yields over stocks and also over traditional bank savings accounts, where yields were constrained by federal government regulation until 1980.

…

What we need is transparency: ways for investors to see information, understand it, and weigh the potential risks and opportunities of their investment options.
Transparency is at the core of effective market regulation, precisely because it empowers investors. Sadly, most efforts to improve transparency are fought by a well-funded mutual fund lobby and its related allies. One recent SEC proposal, to have money market funds mark to market their holdings every day, is one such example. This basic idea would not only give investors greater insight into their holdings. It would also impose a healthy appreciation for liquidity among mutual fund managers. Yet the mutual fund industry predictably has fought the idea.
The industry would be wise to consider what Jack Bogle and others observe: If investors do not feel that mutual funds are protecting their interests, they will not participate in markets—and the markets themselves will suffer.

US Department of Labor, Bureau of Labor Statistics, Tables and Calculators by Subject; Unemployment Rates by Month, http://data.bls.gov/pdq/
SurveyOutputServlet.
8. Council of Economic Advisors, Economic Report of the President 2013,
table B-73, column 9.
9. The money market funds held almost zero assets in 1980. See graph
in “The Future of Money Market Funds,” September 24, 2012, http://www
.winthropcm.com/TheFutureofMoneyMarketFunds.pdf. The numbers in
this graph accord with data from the Investment Company Institute’s 2014
Fact Book. The data do not include the years 1980 to 1984, but they do show
that by 1990 money market fund assets had reached $498 billion. http://
www.icifactbook.org/fb_data.html. Last accessed January 1, 2015.
10. Akerlof and Romer, “Looting,” p. 23.
11. Ibid., p. 34, calculation of resolution cost of $20 billion to $30 billion in
1993 dollars, brought up to date.
12.

It was no longer the firm centered
in a cramped office building at 20 Broad Street notable for its turret
trading desk with 1,920 private telephone lines to its traders.17 It had
expanded worldwide: not only to have offices in New York, London,
and Tokyo; in due course it would include such financial hot spots
as Bangalore, Doha, Shanghai, and even tiny Princeton, New Jersey.18
All of this is symbolized by its “sleek” new headquarters, opened in
2009:19 forty-three stories in height; two city blocks in length; and
described by architecture critic Paul Goldberger as an “understated
palazzo.” Goldman Sachs has become an empire.20
Financially, Goldman’s, like the other investment banks, is now a
“shadow bank.” A good share of its liabilities is rolled over every night.
It takes in “deposits” from large investors with large amounts of liquid assets looking for a haven. Those investors might be commercial
banks, money market funds, hedge funds, pension funds, insur28
Akerlof.indb 28
CHAPTER T WO
6/19/15 10:24 AM
ance companies, or other large corporations. Every night they give
(we might say “deposit”) literally billions of dollars, with the investment banks’ promise to repay the very next day. This arrangement is
known as buying and selling “repos” (repurchase agreements). The
depositor is doubly protected. Not only can it claim its money back
the very next day, but if Goldman’s should fail, it need hardly skip a
heartbeat.

In the 1980s, they began to look for a broader definition of money that would encompass other money-like instruments in addition to cash and demand deposits. New monetary aggregates were devised:
M1 was the name given to the traditional definition of money, i.e., currency plus demand deposits.
M2 includes M1 plus time deposits and money market funds.
M3 includes M2 plus time deposits and term repos.
MZM, money zero maturity, includes M2 less time deposits, but including money market funds.
And there were others.
It had been hoped that some broader definition of money would produce the stable relationship between the quantity of money and the price level that the quantity theory of money asserted should exist. None of the new monetary aggregates succeeded in generating the results anticipated, however.

…

Exhibit 1.7 provides a snapshot of the country’s credit structure in 1945 and in 2007.
EXHIBIT 1.7 Total Credit Market Debt Held by the Creditors
Source: Federal Reserve, Flow of Funds
1945 2007
Total $ billions $355 $50,043
Household Sector 26% 8%
Financial Sector 64% 73%
including:
Commercial banks 33% 18%
Life insurance companies 12% 6%
Savings institutions 7% 3%
GSEs & GSE-backed mortgages 1% 15%
Issuers of asset-backed securities 0% 9%
Money market funds 0% 4%
Mutual funds 0% 4%
Others financial sector 11% 14%
Rest of the World 1% 15%
Miscellaneous 9% 4%
100% 100%
At the end of World War II, the credit structure of the United States was simple and straightforward. It became vastly more complicated and leveraged, however, as time went by and new kinds of financial entities were permitted to extend credit.
In 1945, the household sector supplied 26 percent of the country’s credit.

…

They used the proceeds to buy mortgage loans, credit card loans, student loans, and some other credit instruments, which they then bundled together in a variety of ways and sold to investors as investment vehicles with different degrees of credit risk. They were not significant players in the credit markets until the second half of the 1980s. By 2007, however, ABS issuers supplied 12 percent of the credit provided by the financial sector or 9 percent of all credit outstanding.
Mutual funds and money market funds had also come of age during the 1980s, and by 2007, they provided 6 percent and 5 percent, respectively, of all credit supplied by the financial sector.
Credit without Reserves
By 2007, the GSEs and the issuers of ABSs provided 24 percent of all the credit in the country. Their rise made the financial system much more leveraged and complex than when it had been dominated by the commercial banks.

S&Ls were allowed to pay 1/4 percent more
Broken Markets
than banks, so they had an inside track on collecting household savings to fund
mortgages.When Federal Reserve Chairman Paul Volcker pumped up rates to
break the fever of the Great Inﬂation, the bank prime rate hit 21.5 percent.
Banks were only allowed to pay depositors 5 percent and S&Ls 5 1/4 percent.
Depositors ﬂed both, as the brokerage industry invented money market funds,
which offered market rates.
Congress phased out Regulation Q in the early 1980s (though the prohibition
on paying interest on demand accounts remained until recently) and materially raised deposit insurance. This set off a dangerous competition for deposits
based on high rates, a competition that attracted a lot of opportunistic and
ﬁckle hot money into the banks offering them. Congress also allowed the S&L
industry to enter more lines of business, including commercial real estate lending.

…

When the
players know that they are going to be paid what is owed to them, they will
pay what they owe others, and stark fear will subside while the authorities
“resolve” the hopeless cases, winding down the businesses or selling off the
bits. When banks in the euro zone are stuffed with toxic dollar paper sold to
them by investment banks, and other banks won’t give them overnight loans
and the money market funds won’t buy their IOUs either, things get more
than a little complicated. The markets are too seamlessly interconnected—
too big for the old playbook to work.
When it was ﬁrst spelled out by Walter Bagehot in Lombard Street, the idea
that one bank (in his case, the Bank of England) could hold the reserves of
the whole banking system and lend without stint in a panic against all valid
claims (commonly called the “lender of last resort” role) was controversial
but highly practical.

…

Under normal circumstances, the whole global banking and ﬁnance system
operates like one big happy family in which everyone trusts one another. Banks
can lend money in excess of their deposits not only because they can issue
medium- and long-term debt in the market, but because they can borrow
funds overnight from one another in the interbank market. European banks
can lend their clients dollars because they can issue short-term paper to US
money market funds.They can also hedge their interest rate and currency risks
101
102
Chapter 5 | Global Whirlwinds
with each other and to customers by doing swaps and trading other derivatives with each other.These activities are all absolutely routine and essential to
making the system work.They are also global, with the same big banks operating in multiple centers, including New York, London, Tokyo, and Singapore.

The industry has been made more fragile by creating what Gennaioli, Shleifer, and Vishny term false substitutes—securities that investors believe to be riskless that turn out to be risky. As bad as things got during the worst of the financial crisis, for example, bank customers remained generally calm. There were runs at a few troubled institutions, but often they were the self-policed kind, as large depositors reduced their balances below the limit for federal deposit insurance. Money-­market fund investors were altogether more skittish. A day after Lehman Brothers went bust, the Reserve Primary Fund, the oldest money-market fund, broke the buck when it wrote off its holdings of Lehman debt. Some $300 billion fled the funds in the days following Lehman’s bankruptcy, as investors suddenly realized that they were less protected than they had thought. Talk to regulators about the events of September 2008, and they will tell you that nothing was more alarming than this stampede.

…

An annual survey by McKinsey & Company of the world’s capital markets shows that in 2012, the value of global financial assets (excluding derivatives and physical assets such as property) stood at $225 trillion, $50 trillion of which were “riskier” equities and $175 trillion of which were “safer” loans and bonds.8
The precrisis development of America’s mortgage market conformed to this model: securitizing mortgages and tranching them created a supply of debt instruments that appeared to be as safe as the limited amount of US Treasuries and managed to deliver a little bit more income than normal government debt. So too did the money-market fund, a financial instrument that offered investors the money-like properties of a bank deposit—in other words, the ability to get your cash back immediately without any loss of ­principal—but managed to deliver higher income. It is not the dash for risk that lands the world’s financial system in trouble; it is the hunt for safe returns.
These new instruments are attended by risks that are different from those of the old ones they are substituting for, however.

…

Putting money into highly rated “collateralized-debt obligations” (CDOs), which bundle up the lower tranches of existing securitizations, was an opaque bet that America would not suffer a national housing-market meltdown. Similarly, putting your money into a bank account is a decision that is informed by an explicit system of deposit insurance: you will get your money back because the government guarantees it. For many, investing in a money-market fund is also a bet on a promise, but this time by a private actor not to “break the buck”—in other words, to give a dollar back for each dollar invested.
These new products may look like the old ones, in other words, but there are differences that investors do not fully appreciate. As a result, when those underappreciated risks do surface, they come as a shock to market participants and prompt panic.

Your money market owns “commercial paper” issued by large corporations, which is not insured and can default, whereas your bank accounts are federally insured. So you are being rewarded for taking this risk with extra return.
It’s also true that the mutual fund industry does its best to soft pedal this inconvenient fact. No major fund company’s money market fund has ever “broken the buck,” even though commercial paper does occasionally default. In 1990, paper issued by Mortgage and Realty Trust, held by many large money market accounts, fell into default. Passing these losses onto the shareholders would have resulted in a devastating loss of confidence, and without exception, the fund companies reimbursed their money market funds. One company alone—T. Rowe Price—spent about $40 million repairing the damage. But there is no guarantee that they will always be able to do this. In addition, banks’ yields are hobbled by the necessity of holding reserves—funds that cannot be loaned out.

…

The sooner your children become acquainted with the risk/return nexus and the benefits of diversification, and the earlier they experience financial loss in a protective, supportive environment, the better.
I suggest that at approximately age ten you set up a small portfolio with two or three asset classes, as well as a money market fund in the child’s name. Have him or her learn how to sort and file the statements properly as they arrive in the mail and teach the child how to track the value of each fund. Every quarter, sit down with all involved siblings and have an “investment conference” during which the performance of each account is discussed. Their reward for these chores will be the dividends from the stock and money market funds, as well as half of the remaining increase in investment value, if any, each December 31.
Table 13-9. “Young Yvonne’s” Investment Path: Vanguard Funds.
Note: Funds are added from left to right, in $5,000 increments.

…

Long-duration bonds are generally a sucker’s bet—they are quite volatile, extremely vulnerable to the ravages of inflation, and have low long-term returns. For this reason, they tend to be bad actors in a portfolio. Most experts recommend keeping your bond maturities short—certainly less than ten years, and preferably less than five. From now on, when we talk about “stocks and bonds,” what we mean by the latter is any debt security with a maturity of less than five to ten years—T-bills and notes, money market funds, CDs, and short-term corporate, government agency, and municipal bonds. For the purposes of this book, when we use the term “bonds” we are intentionally excluding long-term treasuries and corporate bonds, as these do not have an acceptable return/risk profile. I’ll admit that this is a bit confusing. A more accurate designation would be “stocks and relatively short-term fixed-income instruments,” but this wording is unwieldy.

They called it the “break the glass” plan, to be activated only in the most dire crisis.
What exacerbated the problem was that the SIVs had funded themselves by selling short-term IOUs (“commercial paper,” in the parlance of Wall Street), often to money market funds. Money funds, regarded as the least risky of investments, were owned by millions of ordinary savers. In other words, financial engineers had contrived to connect safety-minded moms and pops to the mad cow of the financial world—exactly the stuff of which systemic crises are made.
As the value of SIV paper plunged, the money market funds themselves became imperiled. Roughly a dozen of them were on the verge of “breaking the buck”—that is, the net asset value of these funds was about to fall below the par value of $1 that investors had come to assume was guaranteed.

…

Financiers had discovered the key to limiting risk, and central bankers, adherents to the cult of the market, had mastered the mysterious art of heading off depressions and even the normal ups and downs of the economic cycle. Or so it was believed.
Then, Lehman’s collapse opened a trapdoor on Wall Street from which poured forth all the hidden demons and excesses, intellectual and otherwise, that had been accumulating during the boom. The Street suffered the most calamitous week in its history, including a money market fund closure, a panic by hedge funds, and runs against the investment firms that still were standing. Thereafter, the Street and then the U.S. economy were stunned by near-continuous panics and failures, including runs on commercial banks, a freezing of credit, the leveling of the American workplace in the recession, and the sickening drop in the stock market.
The first instinct was to blame Lehman (or the regulators who had failed to save it) for triggering the crisis.

…

While the latter worried about default risk, stock traders, by nature and trade, were more bullish. In early December they lifted the Dow into the upper 13,000s, within 5 percent of its all-time peak. Why such renewed enthusiasm? Traders believed or hoped that Merrill, perhaps even Citigroup, would prosper under new leadership. As for Lehman Brothers, it had thus far escaped with only a modest write-down. The crisis in money market funds had passed, and Citi and other banks had retrieved some of their orphaned SIV assets—a sign to the hopeful that the market could cure itself.
The trouble, which bond traders saw more clearly, was that banks were not manufacturing fresh credits; they were refusing to lend. The cycle described by Rodriguez—falling securities prices leading to losses and thus lessened capital ratios—was, inexorably, putting a damper on credit.

A different mechanism of regulatory arbitrage was created for retail customers – the money market fund. An investor in a US money market fund holds a share in a portfolio of debt, while the manager of the fund is expected to redeem the share at a fixed price and the income from the portfolio is paid to the investors (in effect, the depositors). Cheques can be written on the money market fund, so that in the eyes of the saver, but not of the regulator, the money market fund is a bank account. In the USA these funds have come to rival conventional bank deposits in scale. The role of money market funds is almost entirely confined to countries that have, or once had, significant restrictions on interest on current accounts. In the UK, where no equivalent of Regulation Q has ever existed, money market funds have negligible market share.
Since money market funds were not technically deposits, they did not qualify for deposit insurance.

…

This understatement is much greater under US GAAP than European IFRS, so that US figures are too low relative to the European ones.
Fig. 8 summarises flows through the deposit channel. Total deposits everywhere amount to about one year’s national income. The differences between the USA and the three European countries are more apparent than real. In the USA money market funds (which are effectively deposits) total around $4 trillion, and the main holdings of these money market funds are very short-term securities issued by banks, or the quasi-banks that are the Treasury operations of large corporations such as Apple or Exxon Mobil. This American exceptionalism is one aspect of the general tendency for more intermediation to take place through securities markets in the USA than in Europe. Deposits are mostly savings and transactions balances of households, although the short-term cash holdings of businesses are also significant.

…

However, when the very large Reserve Primary Fund – which held some Lehman debt – ‘broke the buck’ (was unable to offer redemption at the fixed price) in 2008, pressure from aggrieved investors and fear of a run on other funds led to an extension of government guarantees of deposits to such investments. Since 2008 there has been extended – and still inconclusive – discussion of an appropriate new regulatory framework for money market funds.
Regulation Q was gradually weakened and became ineffective after 1980, although it was not finally abolished until 2011. But regulators rarely remove otiose or ineffective regulations. The more usual response is to elaborate the regulation in an attempt to remove or reduce the arbitrage opportunity. Thus begins a game of cat and mouse, in which the financial services companies are generally one or more steps ahead of the regulator.

I suggest you keep as little as possible on hand, consistent with your needs and comfort level.
We used to keep ours in VMMXX (Vanguard Prime Money Market Fund). At the time interest rates were higher and money market funds typically offered better interest rates than bank savings accounts. But with interest rates currently at historic lows, money market funds pay close to zero percent. Bank interest rates are now slightly higher. Plus they come with FDIC insurance on accounts up to $250,000.
For these reasons, we now keep our cash in our local bank and in our online bank, which happens to be Ally. Should interest rates rise and money market funds again offer better rates, we’ll switch back.
So that’s it. Three simple tools. Two index mutual funds and a money market and/or bank account.

…

Treasury Bonds—what the Trust Fund holds—are considered the safest investments in the world. Backed, as the saying goes, by “the full faith and credit of the United States Government.” Of course, that’s us, the U.S. taxpayers and the same folks owed most of the 2.7 trillion.
So the U.S. Treasury Bonds held by the Trust Fund are real things with real value, just like the U.S. Treasury Bonds held by the Chinese, the Japanese, numerous bond and money market funds and countless numbers of individual investors.
Yeah, but I’d still feel better if they hadn’t spent the money I contributed and if it really was cold hard cash in a lock box I could draw on.
Well, OK, but cash is a really lousy way to hold money long term. Little by little inflation destroys its spending power.
It is important to understand that any time you invest money, that money gets spent.

pages: 1,242words: 317,903

The Man Who Knew: The Life and Times of Alan Greenspan
by
Sebastian Mallaby

The Reserve Primary Fund, the oldest money-market fund in the country, held Lehman paper that was now in default: as a result, a dollar deposited in the Primary Fund was now worth only ninety-seven cents. This was the first time in history that a money-market fund had “broken the buck”—puncturing the myth that money-market accounts were as safe as federally insured bank deposits. Investors who had parked around $3 trillion in money-market funds woke up to the horrifying prospect that their cash might go up in smoke; they rushed to yank their money out, forcing the funds to liquidate their portfolios of Treasury bills and other short-term paper. After years in which the Fed’s reassuring policies had made short-term credit plentiful and cheap, the run on money-market funds cut off the supply almost completely.

…

In his attack on Regulation Q interest caps in 1970, James Tobin had emphasized their inefficiency but also their injustice. Wealthy Americans could find their way around regulatory constraints, whereas ordinary citizens were helpless.50
Besides, Nixon’s financial reform commission favored deregulation because there was really no choice but to do so. Since 1970, Americans had been pouring savings into money-market funds, which mimicked the properties of bank accounts but which were not subject to Regulation Q.51 If the government kept the regulatory screws on banks and S&Ls, capital would migrate to these money-market funds; and if the government responded by extending interest-rate caps to the funds, capital would migrate to Europe. Already, a booming trade in dollar-denominated bonds had sprung up in London, and if the government tried to regulate onshore credit markets more aggressively, Europe would gobble up more of the business.

…

And yet this non-outcome proved more significant than it appeared, for it anticipated the story of financial reform during Greenspan’s Fed tenure. Finance did change in the 1970s, but it was shaped not by the deliberate planning of an expert commission but by market pressures and crises. The fact that Greenspan and his fellow commissioners proposed to phase out Regulation Q did not matter in the end; Regulation Q was neutered anyway as savings flooded into the new money-market funds, as unregulated dollar bonds multiplied in London, and as the Fed dealt with the panic following Penn Central by scrapping the Regulation Q cap on the interest that banks could pay to attract very large deposits. The pattern was the same in later years. Finance changed dramatically in the 1990s and early 2000s, but the change was not dictated by the deliberations of experts; earnest working committees pondered the meaning of the new swaps market or the rise of shadow banks, but Greenspan declined to throw his weight behind their ideas, and their findings failed to alter policy.

But neither of Paulson’s strategies has thus far helped to stabilize the situation, with global stock and currency markets gyrating wildly and investors dumping risky business loans in favor of safe Treasury bonds. The crisis has even hit the previously staid world of money market mutual funds, where the fainthearted once could park their savings safely in exchange for low returns.
Money market fund holders have been panic-selling since mid-September, dumping $500 billion worth of these accounts.
To stanch a money market fund collapse, Bernanke announced on October 21 that, on top of the Paulson bailout plan, the Fed stands ready to purchase $540 billion in certificates of deposit and private business loans from the money market funds. This action is in addition to two previous initiatives committing the Fed to buy up, as needed, business loans from failing banks. Until this crisis, the Fed had conducted monetary policy almost exclusively through the purchase and sale of Treasury bonds, rarely buying directly the debts of private businesses or banks.

…

Whole fleets of spaceships then immediately began attacking AIG, Wachovia, Washington Mutual, even Morgan Stanley and Goldman Sachs. Now desperate, the Men in Black switched back to their old tactics and rescued AIG, but the damage had been done. The aliens had learned from Lehman and AIG how vulnerable Wall Street really was. Soon interbank markets everywhere in the world locked up. With financiers preferring treasuries that paid essentially nothing to every other asset in the world, huge runs started on money market funds.
In response, the Men in Black have now gone to Congress.
They have put a check for $700 billion and a loaded gun on the table. Sign the check, they insist, and give us unreviewable power to buy bad assets, or take responsibility for the collapse of the whole financial system and, likely, the world economy.
In America’s money-driven political system, leaders of both parties love to pretend that the sound of money talking is the voice of the people.

…

In sum, the less that is bought, the lower the demand for goods and services and the only thing that goes up on the graphs is unemployment. As the construction industries, among our largest employers, go down the toilet, unemployment rises.
Fear—Franklin D. Roosevelt’s nameless, unreasoning, un-justified terror—is also at work here. It is driving countless people to take what money they have left out of money market funds, cash in stocks at a loss and withdraw money from savings accounts to put it in government notes which, for practical purposes, pay no interest. Money stuck away in government notes and bonds is unproductive money, money that will not be spent to generate wealth. Stagnant money makes for a scum-pond economy and fewer jobs.
Fear has made it next to impossible to borrow for anything—working capital for one’s business, for new ventures, for investment in new equipment.

The creditors absorbed little of the losses, only the U.S. taxpayers did.
Money market funds were also in crisis, perhaps the most dangerous problem of all. They were generally considered as safe as U.S. Treasury bills by their investors, even when their charters allowed them to invest in bank CDs, which many now did. But some had bought Lehman CDs for the higher yield. On Monday, the Reserve Primary Fund, run by the once highly cautious founders of the very first money market fund (see Chapter 6), announced that it had more than 1 percent of its assets in Lehman commercial paper. Its investors, stunned they could lose money at all, immediately began to withdraw what could have amounted to $5 billion from the fund. If investors in other money market funds followed, the consequences were unimaginable. Money market funds would sell their commercial paper willy-nilly.

…

Many bankers were furious that the Reserve Fund took low-cost savers from them, restricted as they were by Regulation Q. At a dinner at the Waldorf-Astoria in New York, John McGillicuddy, the chairman of Manufacturers Hanover, “had to be physically restrained from attacking me,” recalled Bent. But Wriston saw an opportunity. For one thing, such funds invested in his large CDs. More important, the growth of the Reserve Fund and the quick entry into the market of other money market funds encouraged some bankers at smaller institutions to join Wriston’s lobbying efforts against Regulation Q. Until then, small banks supported Regulation Q because it limited the large big-city competitors, which might be willing to pay more for depositor money than the smaller banks could afford.
The impact of another major new development that profoundly changed the financial community was not clear until the 1980s.

…

He hired traders in a variety of new derivatives markets to exploit opportunities. What it boiled down to was borrowing at the low rates fostered by Greenspan’s Fed in the early 1990s—which were almost zero after inflation—and investing the funds in high-paying securities, especially the new kinds backed by mortgages and aggressively peddled by First Boston and Salomon Brothers, in particular, to mutual funds, pension funds, and some money market funds, as well as municipalities. For all the supposed hedging and sophisticated measures of risk, most of these trades were heavy bets that interest rates would stay low.
Another subsidiary of the bank, BT Securities, started creating complex ways for banking clients to borrow funds based on derivatives. BTC’s clients, particularly Gibson Greetings and Procter & Gamble, used these derivatives-based transactions to reduce their borrowing costs, without fully understanding their risks.

A more likely reason is that Mr Paulson believed (wrongly, as it turned out) that the markets would take Lehman’s failure in their stride, but was sure the same would not be true for AIG, given its role as a seller of ‘credit default swaps’ – insurance contracts on bonds, including the securitized assets that had become increasingly toxic.
Then, on 17 September, one of the money-market funds managed by Reserve Management Corporation (a manager of mutual funds) ‘broke the buck’ – that is, could no longer promise to redeem money invested in the fund at par (or dollar for dollar) – because of its exposure to loss-making loans to Lehman. That threatened a tsunami of redemptions from the $3.5tn invested in money-market funds, a crucial element in funding McCulley’s ‘Shadow Banking System’.19
PriceWaterhouseCoopers, the UK’s bankruptcy administrator for Lehman, seized the failed company’s assets in the UK, including the collateral of those who traded with it.20 This came as a shock to many hedge funds and US policymakers.

…

Worse, conventional banks were also implicated in central aspects of shadow banking, the creation of – and trading in – complex securities and borrowing in short-term, collateralized debt markets, which replaced conventional bank deposits for many big lenders.
As is true of most revolutionary systems, the implications of shadow banking were widely misunderstood. It created new forms of non-deposit near-money – notably, money-market funds, predominantly held by households, which financed supposedly safe short-term securities, and repos (repurchase agreements), a form of secured lending by corporate treasurers to investment banks and the investment-banking operations of universal banks (banks that provide both retail and investment-banking services).35 It allowed companies increasingly to issue commercial paper instead of relying on conventional bank loans.

…

These valuable privileges allow banks to expand their lending in good times with next to no constraint. It is easy, after all, for banks to hold on to the deposits they need to fund their expanded lending, precisely because of the public confidence generated by the support provided to banks by the government and central bank. Banks are explicitly part of the government’s monetary system. Of course, once the Federal Reserve offered equivalent support to money-market funds in September 2008, the latter came to have much the same characteristics as banks.
What then stops the bank-led financial system from expanding credit and money without limit? The obvious answer would be that it would stop when participants ran out of profitable opportunities. But this is not a convincing answer if the activities of the hyperactive intermediaries in aggregate create the perceived opportunities: credit growth breeds asset-price bubbles that in turn breed credit growth.

pages: 464words: 139,088

The End of Alchemy: Money, Banking and the Future of the Global Economy
by
Mervyn King

In the run-up to the crisis, new institutions grew up to form a so-called ‘shadow banking’ system. In the US it became larger in terms of gross assets than the traditional banking sector, especially between 2002 and 2007, largely because it was free of much of the regulation that applied to banks. There is no clear definition of what constitutes ‘shadow banking’, but it clearly includes money market funds – mutual funds that issued liabilities equivalent to demand deposits and invested in short-term debt securities such as US Treasury bills and commercial paper.
Money market funds were created in the United States as a way of getting around so-called Regulation Q, which until 2011 limited the interest rates that banks could offer on their accounts. They were an attractive alternative to bank accounts. Such funds – and hence the owners of their liabilities – were exposed to risk because the value of the securities in which they invested was liable to fluctuate.

…

By the time the crisis hit, such funds had total liabilities repayable on demand of over $7 trillion. And they lent significant amounts to banks, both directly and indirectly through other intermediaries.
It was because they were a significant source of funding for the conventional banking system that the Federal Reserve took action to prevent the failure of money market funds in the autumn of 2008 when, after the failure of Lehman Brothers, concern about the ability of such funds to hold their value led to a run on them.32 In Europe and Japan, money market funds did not grow to the same extent because banks had more freedom to pay interest, and since the crisis, unlike in the US, such funds have had to choose between being regulated as banks or becoming genuine mutual funds with a risk to the capital value of investors’ money.
At one time or another, almost all non-bank financial institutions have been described as shadow banks.

…

But on 15 September the long-established investment bank Lehman Brothers failed – its large losses on real-estate lending combined with very high leverage prompted a loss of confidence among the financial institutions that provided it with access to cash. Although hardly surprising given the growing appreciation of the system’s underlying fragility over the previous twelve months, the failure of Lehman Brothers was such a jolt to market sentiment that a run on the US banking system took off at extraordinary speed. The runners were not ordinary depositors but wholesale financial institutions, such as money market funds. The run soon spread to other advanced economies – and so the Great Panic began. Already extremely chilly, the financial waters froze solid. Banks around the world found it impossible to finance themselves because no one knew which banks were safe and which weren’t. It was the biggest global financial crisis in history.
Where banks could still borrow, it was only at a very high premium to official rates.

“For the last couple of years,” noted Michael Gordon, global head of fixed income at Fidelity International, “everyone seemed so comforted that debt and risk were spread so widely. . . . Now everyone is panicking because they don’t know where it is.”13
That same uncertainty about what had been dispersed to where also fed “contagion.” If CDOs and mortgage-backed securities were radioactive, and some had turned up to great dismay in money market funds run by BNP Paribas in France, then money market funds in general became suspect. By mid-August, the most severe of the contagion problems all but froze the commercial paper market.
The Swiss-based and tradition-conscious Bank for International Settlements had issued its cautions in June, and Austrian School economist Kurt Richebächer had been even more damning in earlier warnings. Some of the August crisis gestated in banks within the Federal Reserve Board’s regulatory and rate-reduction orbit, but at least as much of the reckless behavior originated in the burgeoning financial sector’s less-regulated “Wild West”—the phalanx of mutual funds, hedge funds, private equity firms, mortgage entities, conduits, and “liquidity factories” sometimes called the “shadow banking system.”

…

Reserve banking, and the Federal Reserve that regulates the system, appear anemic in comparison.21
These pseudomonetary products fit neither of the two current definitions of money employed by Washington—the narrow M1 (essentially cash, traveler’s checks, and checking accounts) and the slightly broader M2 ( M1 plus most savings accounts, retail money market fund balances, and time deposits under $100,000). However, some think that the new moneylike debt instruments overlap with the definition of M3, the broader money supply that formerly reached measurement into the innards of the financial sector. By definition, M3 includes all of M2 plus large time deposits, institutional money market funds, bank repo agreements, and some overseas Eurodollars. This is the money-supply data that the Federal Reserve decided to stop reporting in early 2006. Let me stipulate: this nomenclature is nerdspeak. The average American would take M1 to mean the standard U.S.

…

The once-sought-after CDOs could no longer be valued or “marked to market,” or even marked to model, the next resort, but only, as skeptics remarked, marked to make-believe, a poisonous perception. Investors heard talk of the possible deleveraging of the global credit bubble—the privately feared “great unwind.” Recession and deflation might be just over the hill. Other financial shivers—trembling municipal bonds, money market funds, and plain vanilla stocks—added to the worst August market chills since the mobilizations of 1914 had shut down bourses on both sides of the Atlantic. (The New York Stock Exchange, closed on July 31, 1914, did not resume full trading for four months.)
The 2007 crisis quickly revealed watershed characteristics. The great credit bubble, over two decades in its shaping, had since the 1980s been kept aloft and generally expanding by uplifts of monetary expansion from the U.S.

Instead, it merely protects individual banks from market discipline. Put differently, with implicit government guarantees all over the place, should we not strive to remove explicit government guarantees where we can?
One reason for insuring deposits was to provide a safe means of savings to households where none existed. Today, this rationale is archaic—a money-market fund invested in Treasury bills can provide that safety. A well-diversified money-market fund invested in highly rated commercial paper and marked every day to market is almost as safe and should not experience the kinds of runs experienced by funds that were not marked to market during this crisis.20
Another important reason for insuring deposits was to ensure that the payment system would be relatively safe: unregulated, unsafe, uninsured entities could not pollute it and cause the system to freeze.

…

Stein, “Rethinking Capital Regulation,” paper prepared for the Federal Reserve Bank of Kansas City symposium “Maintaining Stability in a Changing Financial System,” Jackson Hole, WY, August 21–23, 2008.
16 See Aaron Wildavsky, Searching for Safety (New Brunswick, NJ: Transaction Books, 1988).
17 See Thomas Hoenig, president of the Federal Reserve Bank of Kansas City, “Perspectives on the Recent Financial Market Turmoil,” speech at the 2008 Institute of International Finance Membership Meeting, Rio de Janeiro, Brazil, March 5, 2008.
18 See, for example, the proposed House Financial Regulatory Reform Bill of 2009.
19 See Sorkin, Too Big to Fail, 490.
20 Prime Reserves, a money-market fund, suffered losses on its Lehman debt holdings after the Lehman collapse. Because it paid out $1 for every dollar invested instead of the $0.97 or so that the investments were now worth, investors rushed to the exit to avoid being forced to bear the losses. If the fund had marked its assets to market and paid out only $0.97, there would have been less of a panic. Again, in a crisis, perhaps no asset is safe without a government guarantee, including money-market funds that are invested in anything other than Treasury bills.
21 I thank Viral Acharya for suggesting this term.
22 Louis D. Brandeis to Robert W. Bruere, Columbia Law Review 31 (1922): 7.
23 Louis D.

They were funded mostly through medium-term notes that were liquid, and unlike many of the mortgage products, the fact that they traded frequently meant that they could be marked to actual market trades. But at this point, a whiff of mortgage exposure was enough.
With funding already restricted in the repo market by higher margins and demands for higher-quality collateral, with the ABCP market seizing up and SIVs dead in the water, the fall of 2007 reached a panic point when money market funds started to face problems. SIVs were a particular issue here, because these were held widely by money market funds. The money market funds were a prime source of the raw material—they were the ultimate cash provider—that found its way through the SIVs and other instruments.
Another funding source that got clobbered came through trouble with monoline insurers. The two largest monoline bond insurers, MBIA and Ambac, had taken $265 billion of guarantees on mortgage-backed securities and related structured products.

…

AGENTS
An ABM does not start with axioms; it starts with the reality of the situation. If we are going to look at financial crises, the first step is to recognize that we have a specific financial system with real institutions, organized in a defined way. There are banks like JP Morgan Chase (JPM) and Citi, hedge funds like Citadel and Bridgewater, security lenders, asset managers, pension funds, money market funds. Each one interacts with others; some are sources of funding, others use funding; some are intermediaries and market makers; some act as conduits for collateral, others take on counterparty risk. Each one takes actions based on the world around it, based on its business interests and operational culture, and how it acts—these are big enough institutions that what they do has consequences for the system—in turn changes the environment and affects how others act.

…

Hedge funds are on both sides of figure 11.1 because when they are holding assets short they provide funds to the bank/dealer; when they are going long they borrow. Agents in the hedge funds space include Bridgewater, Citadel, and D. E. Shaw. There are several thousand hedge funds in total, though fewer than one hundred of any note.
Cash Providers. Cash providers are agents that include asset managers, pension funds, insurance companies, securities lenders (who receive cash from lending securities), and, most important, money market funds. The cash providers fuel the financial system. Without funding, the system—or any part of the system that does not have funding—comes to a halt in as little as a day. The collateral passes from the borrowers to the cash providers, usually with the bank/dealer as an intermediary.
Securities Lenders. Like the cash providers, the securities lenders provide the bank/dealer with securities and funding.

In fact, world GDP was only about $45 trillion or so in
2007.
This vast accumulated wealth of households fell into two large
buckets: First, tangible assets of $28 trillion, including over $21 trillion in real estate and $4 trillion in durable goods like cars; and second, financial assets of $50 trillion. Of these, only about $7 trillion
was ‘‘money in the bank’’ such as in checking and savings accounts or
money market funds. Most household financial assets are what are
called ‘‘market instruments.’’ These will be described in detail in the
next chapter, but in general, a market instrument is either an IOU for
borrowed money or an ownership share in a corporation. In other
A Tour of the Financial World and Its Inhabitants
words, what we know as bonds and stocks. Households owned abut
$4 trillion in bonds of various types and $15 trillion in stock, about a
third of it through mutual funds.

…

A Tour of the Financial World and Its Inhabitants
Together, these sums of money make the deposit money in the banking system proper seem modest.
YOUR PENSION FEEDS THE MARKET
At the end of 2007, U.S. households had about $6 trillion in the bank,
mostly in various types of savings accounts. However, the actual
reserves (that is, real money, not just promises) for pension funds was
$13 trillion. Households also held $5 trillion in mutual funds and
another $1.4 trillion in money market funds. Their life insurance policies held another $1.2 trillion in reserves. The ‘‘buy side’’ is huge, and
for a very good reason. The only way anyone can continue to have an
income after they stop working is to put aside money today that they
can use later in life. If the average person needs $40,000 a year to live
in retirement and will on average live twenty years, that means that
they need $800,000 over that period.

…

Second, CP had been a building block in a Rube Goldberg scheme
called ‘‘asset securitization,’’ another ugly phrase, this time relating to
complicated financial machinery that transforms bank loans into
marketable ‘‘financial instruments.’’ Asset securitization is what
allowed the great credit bubble of recent decades to inflate and then
collapse, with asset securitization causing the bubble to pop and tank
the real economy in the process. Commercial paper was an essential
ingredient in the whole witches brew, as we will see later. Who bought
all these naked IOUs? The short answer is that you did. Money market funds, which so many of us used to get higher returns on our savings, were among the biggest buyers of CP. The riskier the CP issuer,
the higher the rate they paid us. Nobody questioned this when times
were good.
BONDS
If you watch the TV money shows, you will see how much drama surrounds the trading floor the New York Stock Exchange. People clap
when the bell goes off at 9:30. People run around.

He was most anxious
about the latest shocking development: A giant money market fund, Reserve Primary Fund, had
broken the buck a day earlier (which meant that the value of the fund’s assets had fallen to below a
dollar per share—in this case, 97 cents). Money market funds were never supposed to do that; they
were one of the least risky investments available, providing investors with minuscule returns in
exchange for total security. But the Reserve Primary Fund had chased a higher yield—a 4.04
percent annual return, the highest in the industry—by making risky bets, including $785 million in
Lehman paper. Investors had started liquidating their accounts, which in turn forced managers to
impose a seven-day moratorium on redemptions. Nobody, Geithner worried, knew just how
extensive the damage could end up being.
Between the money-market funds being under pressure, Geithner thought, and billions of dollars
of investors’ money locked up inside the now-bankrupt Lehman Brothers, that meant only one
thing: the two remaining broker-dealers—Morgan Stanley and Goldman Sachs—could actually be
next.
259
The panic was already palpable in John Mack’s office at Morgan Stanley’s Times Square
headquarters.

…

CHAPTER EIGHTEEN
Hoarse and a little haggard, Paulson made his way to the podium in the press room of the Treasury
Building the morning of Friday, September 19, 2008, to formally announce and clarify what he
had dubbed earlier that morning the Troubled Asset Relief Program, soon known as TARP, a vast
series of guarantees and outright purchases of “the illiquid assets that are weighing down our
financial system and threatening our economy.”
He also announced an expansive plan to guarantee all money market funds in the nation for the
next year, hoping that that move would keep investors from fleeing them. But he had already
gotten an earful that morning about that effort from Sheila Bair, chairwoman of the FDIC, who
had called, furious she wasn’t consulted and anxious that the guarantee plan would backfire and
investors would perversely start moving their money out of otherwise healthy banks and into the
guaranteed money market funds. Paulson just shook his head; he couldn’t win.
As he stood in front of the press corps he did his best to sell the centerpiece of his plan, the TARP.
“The underlying weakness in our financial system today is the illiquid mortgage assets that have
lost value as the housing correction has proceeded.

…

Although the conversation
agitated Fuld slightly, they’d had similar discussions before, so he took Paulson’s advice in stride.
The group took their seats, and as each of the speakers took the podium, the perilous state of the
economy became ever clearer. The credit crisis wasn’t just a U.S. problem; it had spread globally.
Mario Draghi, Italy’s central bank governor and a former partner at Goldman Sachs, spoke
candidly of his worries about global money-market funds. Jean-Claude Trichet told the audience
that they needed to come up with common requirements for capital ratios—the amount of money a
firm needed to keep on hand compared to the amount it could lend—and, more important,
leverage and liquidity standards, which he thought was a much more telling indicator of a firm’s
ability to withstand a “run on the bank.”
That night, after Fuld had finally found his car and driver outside the Treasury Building, he
thumbed out an e-mail on his BlackBerry to Russo.

Orange County, California, lost millions on derivatives, and filed for bankruptcy rather than tax its rich citizens enough to make good on their debts,'^ and a small army of Wall Street hotdogs were either badly wounded or driven (at least temporarily) out of business. To avoid embarrassment and possible runs, several prominent mutual fund companies had to subsidize derivatives losses in bond and money-market funds.
People heard and said bad things about derivatives without too clear a sense of what they are. The word refers to a broad class of securities — though securities seems too tangible a word for some of them — whose prices are derived from the prices of other securities or even things. They range from established and standardized instruments like futures and options, which are very visibly traded on exchanges, to custom-made things like swaps, collars, and swaptions.

…

No other industrial country offered fixed-rate loans, since they put all the financial risk of higher interest rates onto the lender; with floating-rate or adjustable loans, the borrower bears all the risk (Lomax 1991; U.S. Congressional Budget Office 1993)- Thrifts were insulated from competition by limits on commercial bank deposits
Thrifts prospered during the housing boom that followed World War IL Deposits and mortgage loans soared, though capital ratios sank as profits lagged growth. Growing competition from banks for both deposits and mortgage loans in the 1960s and money market funds for deposits in the 1970s drew customers away from thrifts. Worse, the inflation and high interest rates of the later 1970s exposed the S&Ls' tragic flaw, borrowing short to lend long: depositors tempted by higher rates in the unregulated world were free to withdraw on a whim, but their funds had been committed by thrift managers to 30-year mortgages. As rates rose, the value of outstanding mortgages sank (like bonds, loan values move in the opposite direction of interest rates).

…

(Major central banks, that is; the Fed and the Bundesbank are mighty, but the Bank of Mexico is weak and the Bank of Zaire little more than a joke.) Since financial asset prices are built largely of expectations about the future, stimuli or depressants to those expectations bear very directly on their prices. Optimism boosts prices, and pessimism depresses them. Relative attractiveness of alternative investments. When interest rates are low or falling, people despair of the earnings on their Treasury bills, bank deposits, or money market funds; they search for juicier profits, and plunge into stocks or long-term bonds, which typically pay higher interest rates than short-term instruments. But when rates are rising, the relative attractiveness of short-term investments rises. If you can earn 7% on a CD, it may not be worth taking the extra risk of holding stocks; but at 2% interest rates, stocks seem much less intimidating — irresistible even.

In September 1998 global capital markets were hours away from total collapse before the completion of a $4 billion, all-cash bailout of the hedge fund Long-Term Capital Management, orchestrated by the Federal Reserve Bank of New York. In October 2008 global capital markets were days away from the sequential collapse of most major banks when Congress enacted the TARP bailout, while the Fed and Treasury intervened to guarantee money-market funds, prop up AIG, and provide trillions of dollars in market liquidity. In neither panic did the Fed’s imaginary bargain hunters show up to save the day.
In short, the Treasury and Fed view of financial warfare exhibits what intelligence analysts call mirror imaging. They assume that since the United States would not launch a financial attack on China, China would not launch an attack on the United States.

…

This caused Korea to cut interest rates to cheapen its currency, and so on around the world, in a blur of rate cuts, money printing, imported inflation, and knock-on effects triggered by Fed manipulation of the world’s reserve currency. The result is not effective policy; the result is global confusion.
The Federal Reserve defends its market interventions as necessary to overcome market dysfunctions such as those witnessed in 2008 when liquidity evaporated and confidence in money market-funds collapsed. Of course, it is also true that the 2008 liquidity crisis was itself the product of earlier Fed policy blunders starting in 2002. While the Fed is focused on the intended effects of its policies, it seems to have little regard for the unintended ones.
■ The Asymmetric Market
In the Fed’s view, the most important part of its program to mitigate fear in markets is communications policy, also called “forward guidance,” through which the Fed seeks to amplify easing’s impact by promising it will continue for sustained periods of time, or until certain unemployment and inflation targets are reached.

…

A sound euro is an important attraction for Chinese capital because a stable currency mitigates exchange-rate risk to investors. Indeed, capital inflows from China provided support for the euro—an example of a positive feedback loop between a sound currency and capital flows.
Increasing capital inflows to the Eurozone were not limited to those coming from China. The U.S. money-market industry has also been investing heavily in the Eurozone. After panicked outflows in 2011, the ten largest money-market funds in the United States almost doubled their investments in the Eurozone between the summer of 2012 and early 2013.
The Berlin Consensus is taking root in Europe, based on the seven pillars and directed as much from the EU in Brussels as from Berlin, to mitigate resentment of Germany’s economic dominance. The consensus is powered by a virtuous troika of German technology, periphery youth labor, and Chinese capital.

Marlena Lee, a research associate at Dimensional Fund Advisors with a Ph.D. from the University of Chicago wrote an unpublished study on bond fund returns in 2009. Lee analyzed 2,353 bond funds over the period from January 1991 to December 2008. The data included investment-grade, high-yield, and government bond funds from the CRSP Survivor-Bias-Free U.S. Mutual Fund Database. It excluded municipal bond funds, money market funds, index funds, and asset-backed funds.4
Lee used a five-factor risk model for her analysis. The five-factor model was based on the Fama-French Three-Factor Model plus two bond specific risk factors: term risk and default risk. This model was modified from an earlier five-factor model introduced by Fama and French in 1993.5 Lee concluded that the average underperformance of actively managed bond funds was 0.9 percent after adjusting for risk.

…

The plan sponsor should have a well articulated policy for selecting investment options and a method for reviewing those options on an annual basis.
Later chapters make a detailed case for passive investing for institutional investors. Chapter 12 covers charities and private trusts, while Chapter 13 covers pension funds and self-directed employer-sponsored plans such as 401(k) plans.
Step 2: Study Market Risk and Estimate Returns
Asset classes are broad categories of investments such as stocks, bonds, real estate, commodities, and money market funds. Each asset class can be further divided into categories. For example, stocks can be categorized into U.S. stocks and foreign stocks. Bonds can be categorized into taxable bonds and tax-free bonds. Real estate investments can be divided into owner-occupied residential real estate, rental residential real estate, and commercial properties.
The subcategories can be further divided into investment styles and sectors.

…

A good way to look at asset allocation is as if an investor has two portfolios: a short-term portfolio for current cash needs plus emergency money and a long-term portfolio that provides cash for long-term liabilities and builds wealth. This approach is no different than a corporate balance sheet where current assets and current liabilities are separate from long-term assets and long-term liabilities plus owner’s equity.
The short-term portfolio should be in safe assets such as money market funds, certificates of deposit, and short-term bond funds. The return on these investments won’t be high, but a high return is not the primary reason for investing this money. Safety is the most important objective. No investor should risk this capital because it’s needed to pay bills over the next year.
The investments in the long-term portfolio should be more aggressive. Time is on the side of these assets, and it’s appropriate to take some risk in equities and perhaps higher risk fixed income to potentially earn a higher return.

By the mid-2000s, this business and the institutions behind it had grown exponentially to form a shadow banking system with twin operations in the interdependent New York and London markets. Simultaneously, they had paved the way for the new financial industries of hedge funds – investment vehicles constructed solely to take high-risk positions in the quest for unprecedented gain – private equity and money market funds.
But many of the new institutions – the money market funds, the hedge funds and even the investment banks themselves – did not have access to a central bank acting as lender of last resort; nor did they have any form of deposit insurance. Furthermore, in the guidelines for the 2004 Basel prudential banking rules – so-called Basel 2 – the international regulators amazingly handed back to the banks responsibility for assessment of their own risk and thus left them to decide the amount of capital they should hold.

…

If they can build up a position of leveraged lending to a portfolio of borrowers, especially in a class of assets that are appreciating in value, there are fortunes to be made for both financiers and their shareholders. Nor does greed play a particularly overwhelming role. The natural pressures of competition alone drive down the returns on lending while the demand to show good and rising returns mounts – forces on their own that encourage riskier lending. From the 1970s through to the 2000s, banks faced ever more competition for depositors’ cash: money market funds in the United States and demutualised building societies in the UK offered ever more attractive rates to depositors while large corporations built up treasury departments whose sole raison d’être was to maximise the interest on their cash. At the same time, transient, footloose shareholders demanded higher and quicker profits. Caught in this pincer, even the most conservative banks started to consider higher leverage or investing in riskier assets as the only means to survive.20
Unregulated nineteenth-century banking witnessed Northern Rock-type bank runs aplenty.

…

China was already in the process of proving that all of this was bunk by financing its world-beating growth through tightly controlled and regulated banks, but that did not stop the advocates of deregulation touting their theories with ever more zeal.24 Nothing could shake the consensus that lifting controls was good for everyone, and any costs were but transient blips on the road to the Nirvana of a competitive, deregulated banking system. The problem was that there was no steady-as-she-goes middle way. Deregulation was unstable. Once it had begun in one field, its logic demanded that it should be extended to others. Allow money market funds to compete for deposits, for example, and soon policy-makers had to allow banks to fight fire with fire by lifting controls on their interest rates. A level playing field demanded that the entire terrain had to become deregulated.
The first British experiment in deregulation gave a warning of what was to come. In 1971 the banks were given greater freedom to borrow and lend. They instantly all lent more money to homebuyers, relaxed credit-worthiness terms and saw house prices rocket.

A History of the Boom, 1982–1999 (New York: HarperBusiness,
2003), p. 114.
22Food and beverage inflation was 4.6 percent in 1990; www.bls.Gov/opub/ted/1999/
Jun/wk5/art01.txt.
This does not seem like the time the population at large would embrace the stock market. The recession led to a slowing of consumer borrowing, yet net cash flows into stock mutual funds rose from $8 billion in 1985 to $13 billion in 1990 to $79 billion in 1992 and to $127 billion in 1993. In 1992 and 1993, money market funds suffered net outflows.23 The stock market was about to replace the bank deposit system (and money market funds) as the backbone of household wealth.
The Recovery: Cutting Workers and Investment
The economists declared the recession was over in March 1991, but there was little evidence of a recovery. Moreover, the large layoffs that followed were different from previous recessions; now, management was dismissed en masse. When 70,000 workers were laid off from General Motors in December 1991, CEO Robert Stempel announced that GM’s salaried workforce (that is, management) was being cut from 140,000 in 1985 to 70,000 by 1995.24
The median household income fell from $46,670 in 1989 to $44,665 in 1994.

…

At the August 16 meeting, Greenspan expressed satisfaction: “I think we clearly demonstrated that the bubble for all practical purposes has been defused.”37 The FOMC raised the funds rate another 0.50 percent at this meeting, to 4.75 percent. (It would follow with two more rate increases, to 6.0 percent, by February 1, 1995.)
Greenspan was also forthright in public. On May 27, 1994, he told Congress that depositors had shifted their money out of banks and from money market funds into stocks and bonds, “and some of those buying the funds perhaps did not fully appreciate the exposure of their new investments to the usual fluctuations in bond and stock prices.”38 The Federal Reserve chairman was obviously well versed in the novice investor’s exposure to unfamiliar territory.
Derivative Lessons
Greenspan witnessed derivative mayhem when he raised the funds rate from 3.00 percent to 3.25 percent.

…

The Federal Reserve—or, rather, central banking as a whole—is not the sole cause of disturbances, but neither is it what it pretends to be.
Alan Greenspan condemned asset inflation during the 1950s and 1960s; by the 1990s, he claimed that it didn’t exist, and even if it did, there was nothing that the Federal Reserve could do, since it could not recognize a bubble. The oldest generation was not up to running these personal hedge funds; it earned 1 percent on money market funds and ate cat food.
Ben Bernanke has driven short-term interest rates below zero (after subtracting price inflation) to refloat the financial system that the Fed has overindulged and mismanaged at every turn. Now, suffering another asset deflation—following another asset bubble—the Federal Reserve is driving the young and old to cat food.
Only Congress can dissolve the Federal Reserve. It is time to do so. 53 Sidney Homer and Richard Eugene Sylla, A Profile of Interest Rates, 4th ed.

If you fear that your job is in jeopardy, or you think it will
c01.indd 6
26/02/13 11:18 AM
Committing to Living within Your Means
7
take you longer than six months to get back on your feet financially
should you lose your job, you should try to have even more in
savings. Also, if you are saving for anything other than the proverbial rainy day, such as for a house, wedding, new car, or special trip,
count these funds as extra. (It might even be helpful to open a
separate savings account for these larger separate items you are
saving for.)
Given the relatively low interest rates offered at this time on
cash instruments (which include savings accounts, money market
funds, and certificates of deposit, or CDs), and the fact that the
current rate of inflation is higher than the interest rate, you may
actually be losing money on the ultimate purchasing power of your
savings. However, do not let this alarm you too much. Saving in this
way is still an essential part of getting to point X. Also, these savings
come with Federal Deposit Insurance Corporation (FDIC) insurance of up to $250,000 per depositor, so your money is safe.

…

You should consult with your
representative before making any investment decision.
c03.indd 32
26/02/13 4:52 PM
Determining Your Financial Position
33
$750,000. Furthermore, James’ investment portfolio, variable annuity, and IRA accounts are 100 percent invested in stock. This is not
a well-balanced portfolio, and he may be taking on too much risk.
Conversely, Patricia has 100 percent of her IRA account in money
market funds, which are currently paying 0 percent! It seems clear
that they need professional guidance and management from a
financial advisor to help them diversify their investments so that
they can both minimize their risks and maximize their returns.2
With regard to their retirement accounts, they have a total of
only $55,500, which includes a variable annuity and their IRA
accounts. As a couple, they always had an excuse for not funding
their retirement account and instead chose to buy an expensive
home, go into private practice, and purchase an office building.

…

Investments in prepaid tuition plans are also sometimes guaranteed
by the sponsoring state government.
Savings 529 tuition plans generally allow you to establish an account
for a beneficiary for the purpose of paying the beneficiary’s qualified educational costs. As the account holder, you typically have several investment choices for your contributions in the 529 savings plan,
which typically include stock and bond mutual funds as well as money
market funds. Some also offer age-based portfolios. You can usually
use the distributions from 529 savings plans at any U.S. college or university. Your beneficiary has the flexibility of choosing any college or
university he or she gets accepted to, in any state. It is important to
note that the investments in these 529 savings plans are not guaranteed by state governments.
Prepaid 529 plans are treated differently than 529 savings plans
because they are considered resources rather than assets.

By the late 1960s, companies were touting “hot” fund managers and treating them like Hollywood stars. Volatility in such funds was increasing dramatically, but the growth of inflation in the 1970s meant that investors were desperate to earn a decent return. Despite the risks, they began moving money from bank deposit accounts to money market funds and mutual funds. This shift, as we have seen, had the domino effect of encouraging the banking industry to push for deregulation that would allow it more access to the consumer market, contributing to debacles like the 2008 subprime crisis. “With the rise of bond funds and money market funds, nearly all of the major fund managers—which for a half-century had primarily operated as professional investment managers for one or two equity funds—became business managers, offering a smorgasbord of investment options,” says Bogle.12 Suddenly the primary goal of funds wasn’t to earn steady returns for clients, but to earn profits for the firm.

…

The very riskiest portion of the markets, derivatives trading, actually grew following the crisis. Globally, it was 20 percent bigger in late 2013 than in late 2007 (and US regulators are trying to police it with budgets that haven’t increased much since then).6
And that’s just what we can see. Shadow banking, the portion of the financial industry that remains largely unregulated (and includes hedge funds, money market funds, and financial arms of big companies like GE), has grown like kudzu: swelling by more than $1.3 trillion per year since 2011 and reaching $36 trillion today.7 Through it all, low interest rates set by the Federal Reserve, which were supposed to help individuals, ended up making the rich richer by inflating the stock market rather than improving the ability of real people to refinance their homes.

…

Just think of the demise of the hedge fund Long-Term Capital Management and the global market ripples it created; the government’s intervention to offset the impact of the fund’s failure belies the notion that shadow banking entities don’t enjoy federal backstopping of the Too Big to Fail kind, albeit implicitly rather than explicitly.
Since the financial crisis of 2008, it’s the shadow banking sector rather than the federally guaranteed banks that has grown like kudzu, as risk migrates to the darkest parts of the system. While the share of formal bank assets has declined as a percentage of the total global financial system, shadow banks (which include not only private equity but also hedge funds, money market funds, structured finance vehicles, real estate investment trusts, and other exotic, acronym-wielding creatures) grew by 10 percent in 2014 alone, reaching $36 trillion, or more than twice the size of the U.S. economy.45 It’s telling that as regulators have tried with varying degrees of success to shine a light on the formal banking sector, money, talent, and risk have quickly fled to the informal sector.

How they use that power depends on all the complex pressures listed in the previous paragraph. But that does not alter the fact that they and they alone have the arbitrary power to determine the quantity of what economists call base or high-powered money—currency plus the deposits of banks at the Federal Reserve banks, or currency plus bank reserves. And the entire structure of liquid assets, including bank deposits, money-market funds, bonds, and so on, constitutes an inverted pyramid resting on the quantity of high-powered money at the apex and dependent on it.
Who are these nineteen people? They are seven members of the Board of Governors of the Federal Reserve System, appointed by the president of the United States for fourteen-year nonrenewable terms, and the presidents of the twelve Federal Reserve banks, appointed by their separate boards of directors, subject to the veto of the Board of Governors.

…

Credit at the local grocery store is not likely to be as readily available to smooth over discrepancies between receipts and expenditures.
At the other extreme, in financially advanced and complex societies, such as the United States today, a wide array of assets is available that can serve as more or less convenient temporary abodes of purchasing power. These range from cash in pocket, to deposits in banks transferable by generally accepted check, to money-market funds, credit-card accounts, short-term securities, and so on, in bewildering variety. They reduce the demand for real cash balances narrowly defined, such as currency, but they may increase the demand for real cash balances more broadly defined by making temporary abodes of purchasing power useful in facilitating shifts between various assets and liabilities.*
(2) Cost. Cash balances are an asset and, as such, an alternative to other, kinds of assets, ranging from other nominal assets, such as mortgages, savings accounts, short-term securities, and bonds, to physical assets, such as land, houses, machines, or inventories of goods, which may be owned either directly or indirectly, via equities, or common stocks.

…

In addition, inflation in the United States produced a rise in nominal interest rates that converted the government's control, via Regulation Q, of the interest rates that banks could pay from a minor to a serious impediment to the effective clearing of credit markets. One response was the invention of money-market mutual funds as a way to enable small savers to benefit from high market interest rates. The money-market funds proved an entering wedge to financial innovation that forced the prompt relaxation and subsequent abandonment of control over the interest rates that banks could pay, as well as the loosening of other regulations that restricted the activities of banks and other financial institutions. Such deregulation as has occurred came too late and has been too limited to prevent a sharp reduction in the role of banks, as traditionally defined, in the U.S. financial system as a whole.

Apparently you need to have at least one physical location, but nobody was ever expected to visit it.
Want to know something more outrageous? The firm sent out a letter to all of their clients that held individual retirement accounts (IRA) accounts that year. It was a friendly letter informing them that their money market fund, which was where excess cash in the brokerage accounts was held, would be changed over to the “Bank Sweep” feature. On the surface this sounded great. You would have FDIC insurance on what was before just a money market fund, not insured by anything but the assets in that fund. But what was really happening? The brokerage firm was switching tons of assets from the brokerage side to the banking side to boost the bank’s deposits. It was nuts. Overnight, a bank that had nothing but a call center and a single location in Reno was now ready to start borrowing money from the Federal Reserve based on deposits that were created overnight with the click of a mouse.

…

You can’t concentrate all of your money into one illiquid sector of the market just because the rates are above normal. They are high for a reason. Here is the classic rigged system where well-meaning people rig themselves. In order to keep up with the competition during the housing bubble, credit unions had to attract more money from depositors to make loans. They juiced up returns like banks and money market funds with questionable pools of residential mortgages. We know the rest of the story.
So, after the warm and fuzzy people-before-profits system was in place, it rigged itself out of billions of dollars and had to be bailed out just like the evil for-profit bankers. This doesn’t mean you shouldn’t support your local credit union if you have the opportunity. It does mean that we are still trapped by the larger institution of Wall Street no matter what our intentions are as consumers.

The consequences for individual investors and the economic health of the country are almost too painful to contemplate.
The financial markets reeled as they absorbed all the news. Gold had its biggest one-day move in history on Wednesday, September 17, roaring up $70 in the market, up a total of $84 in after-market trading; Reserve Primary Fund, the nation’s oldest money market firm, “broke the buck,” its share value falling below the $1.00 money market fund standard, thanks to losses from its holdings of Lehman securities; that day the Commerce Department reported housing starts hit a seventeen-year low in August, down 33 percent from a year earlier.
In the midst of events, Treasury Secretary Henry Paulson and Ben Bernanke met with President Bush. It was Thursday, September 18. The New York Times reported months later that Bush wondered aloud that day, “How did we get here?”

…

Even as Bush was meeting with Bernanke and Paulson and wondering what happened, the Federal Reserve came up with $280 billion to provide liquidity to the markets. By seven o’clock in the evening, the secretary and the chairman were meeting with congressional leaders to discuss what eventually became the $700 billion taxpayer-funded bailout. The next morning, Friday, September 19, Paulson announced the establishment of a U.S. guarantee program for the money market fund industry, funded with $50 billion from the Exchange Stabilization Fund, a government fund used for currency manipulation. On Saturday, September 20, an overnighted bailout bill was in the hands of lawmakers. It was a simple, three-page, $700 billion package which raised the debt ceiling to $11.315 trillion. And it included a little self-referential, Constitution-upending twist that maintained that decisions by the secretary under that act “may not be reviewed by any court of law or any administrative agency.”

…

Other currency ETFs include:Brazilian Real: BZF
New Zealand Dollar: BNZ
Indian Rupee: ICN
Chinese Yuan: CYB
The foregoing are WisdomTree Dreyfus currency ETFs. Reading the prospectus of any fund is recommended before investing. These may be found at www.wisdomtree.com.
There are a couple of things to bear in mind about currency ETFs. Although the expense ratios are reasonably low, generally around 0.4 percent, you will pay a commission to buy and sell them just as you would any other ETF. This can make them an expensive substitute for a money market fund. The interest rate is not fixed but can change from day to day just as does a money market account. Remember that if you invest in a foreign currency ETF in an account here in the United States, you still have an investment in the United States and you should not mistakenly believe you have money out of the country. There are also leveraged and bundled currency ETFs, packaging different currencies together.

Morgan Stanley also started making some of its financial statements more transparent by specifying the contents of corporate and other debt, which it had not done in previous financial statements.
CHAPTER 12
The Absurdity of Imbalance
Next to love, balance is the most important thing.
—John Wooden
When Lehman Brothers went into bankruptcy, the first sign of trouble happened in a money market fund called the Reserve Primary Fund (RPF). With $65 billion in assets, the RPF was one of the largest money market funds in the United States. Money market funds are a short-term savings vehicle and are considered extremely safe, because they invest in short-term, safe assets.
One of RPF’s investments was in Lehman Brothers commercial paper, which companies issue for short-term financing. When Lehman Brothers went bankrupt, the RPF lost $785 million from its Lehman exposure.

…

CHAPTER 11
The Lehman Bankruptcy
There’s no doubt that things feel better today, by a lot, than they did in March…the worst is likely to be behind us…
—Hank Paulson, Treasury Secretary, May 6, 2008
Seven days after the government rescued Freddie Mac and Fannie Mae, Lehman Brothers declared bankruptcy. Their failure made commercial paper markets falter, making it difficult for companies to borrow short-term funds. It caused a run on money market funds, created an imbalance in the bond and swap markets, and depressed the stock market.
Lehman failed because of its large real estate exposure and because of a market that didn’t trust its solvency, leading to a run on the bank and guaranteeing its failure. The government did nothing to rescue Lehman.
To understand Lehman’s failure and its place in the subprime debt crisis, it’s important to also understand the intricate details of the investment banking business, as well as major investment banks’ leverage and real estate exposures.

…

When Lehman Brothers went bankrupt, the RPF lost $785 million from its Lehman exposure. The fund “broke the buck,” meaning its net asset value was less than $1 a share. It was losing money, which is nearly unheard of in a short-term, almost riskless investment.
Investors began to panic. The RPF had a total of $39 billion in withdrawals, and other crowds withdrew money from other money market funds, pulling a total of $172 billion from a $3.45 trillion market.
The market stopped trusting commercial paper. Commercial paper yields shot up, going from 10 basis points over the Federal Funds rate to 150 basis points over the Fed Funds rate in just two days. Large U.S. companies fund themselves through the commercial paper market, and the yield spike made it too costly for them to finance their activities. The Federal Reserve moved quickly and launched new programs to help resolve the mess that they had created by letting Lehman fail.1
The price of short-term lending between banks also soared as trust between banks weakened.

Adaptive Markets: Financial Evolution at the Speed of Thought
by
Andrew W. Lo

Once Lehman Brothers declared bankruptcy on September 15, 2008,
the bonds issued by this venerable 158-year-old investment bank became nearly worthless. The next day, the Reserve Primary Fund, a money
market fund with about $65 billion in assets, announced that they were
“breaking the buck”—shares in their fund that were supposed to be valued
at $1.00 were now worth 97 cents. Many customers treat their money
market funds like a bank’s checking account; what would you do if
your bank told you that the assets in your checking account just lost 3
percent in value overnight? The difference is that the Federal Deposit
Insurance Corporation (FDIC) insures the assets in your checking account up to $100,000, while money market funds were not insured at
that time (now they are).
By Thursday, September 18, 2008, Federal Reserve Chair Ben Bernanke was telling key legislators that without immediate action, “we
may not have an economy on Monday.”3 There’s very little evidence he
was mistaken.

…

It’s meant for the so-called “qualified”
or “sophisticated” investor—meaning the investor must have enough
money not to worry about losing it all. Currently, the legal definition of
a sophisticated investor is someone with at least $2.5 million in net worth.
Because such investors can withstand significant financial losses, and are
assumed to understand the risks of a private investment partnership,
hedge funds are under much less stringent regulation than a mutual
fund or a money market fund. Hedge funds used to be almost completely
unregulated, but under the Dodd-Frank Act of 2010, hedge funds are
now required to register with the Securities and Exchange Commission
(SEC) and provide a certain amount of information to the government.
Even so, there are still very few restrictions on what a hedge fund can
or can’t do. They can take on all sorts of investment opportunities across
different asset classes, in different countries, buying long, selling short,
at lightning speed or more slowly, and so on.

…

The short answer is: everybody.
At least while housing prices were rising and interest rates were falling.
The particular species of the financial ecosystem that benefited from the
real estate boom were (in alphabetical order): central bankers; commercial banks; credit rating agencies; economists; government-sponsored
enterprises; hedge funds; homeowners; insurance companies; investment banks; investors; money market funds; mortgage lenders, brokers,
servicers, and trustees; mutual funds; regulators; and politicians. Everyone had an incentive to keep the bubble growing, since a rising tide
lifts all boats. As Warren Buffett warned, however, it’s only when the
tide goes out that you find out who’s swimming naked. Apparently a
great deal of skinny-dipping had been going on.
CLEAR AS RASHOMON
Given these facts, making sense of the financial crisis is an ongoing
challenge.

States, municipalities, agriculture, and other borrowers have borrowed excessively because money has been cheap.
Banks have invested heavily in long-time bonds. A great volume of short-time money market funds has been diverted to
capital uses . . .
For the world as a whole, capital is scarce after ten years of war
and disorganization. Its apparent abundance is due to abnormal money market conditions, both in the United States and
abroad, and to the fact that capital is unwilling to venture into
many countries and great industries which badly need it, and
which, with a restoration of confidence, would be effective bidders for it. Men who use money market funds at low rates for
capital purposes may expect a rude awakening when the tide
turns . . .
Capital in London and New York prefers the 2% or 3% it can
get with safety to the 10%, 15%, or 30% which it might have in
these countries under existing conditions of grave risk . . . 44
Although, for example, the investing public in New York did eventually snap up bonds marketed at high interest rates and face value discounts ($200 million of German bonds sold out in one day after the
62
ENDLESS
MONEY
Dawes plan was approved), generally the debt saddling the world was
intergovernmental and related to the triangle of the United States, the
allies, and the Germans.

…

Internally, Fed officers called
this the “finger in the dyke” strategy, implying that the 100-year flood
of bad credit might magically recede in a reasonable period of time.
During the year, the financial community’s perception of the crisis
would change. Initially problems were thought to be contained in the
subprime sector or within specific institutions. Once the equity market collapsed beginning in September, bank deposits took flight, some
money market funds had failed, and it became clear a systemic meltdown had occurred.
As of March 31, 2008, only $170 billion of what the IMF and others projected as likely losses of nearly $1 trillion on subprime assets had
been recognized. The perception of the extent of the credit crisis steadily worsened through the year. In early March 2008, Standard & Poor’s
pegged total losses at only $285 billion; later in that month Goldman
Sachs economists bumped this to $400 billion and then $500 billion.9
By August 2008, Bloomberg reported that U.S. bank losses from the
credit crunch crossed the $500 billion mark, but this had been offset
somewhat by the raising of $358 billion of capital.

…

Bear Stearns and Lehman were large, but not
dominant forces in 2008. Their failure at any other time would have
been easily contained. Some 38 percent of total deposits nationwide
of $7 trillion were uninsured because they exceed the $100,000 limit,
yet less than 15 years ago only 23 percent were.8 With the passage of
TARP, the ceiling was reset at $250,000, but this leaves 27 percent
of depositor funds unprotected.9 With money market funds losing
assets, it is possible that new deposits above the limit could enter the
banking system.
Since the Great Depression, credit grew relative to GDP by an order
of magnitude. Private debt was just 57 percent of GDP in 1944, with
only 14 percent of this being mortgages. By 1954 it would be 71 percent, with 28 percent of this financing residential dwellings. These statistics would not skip a beat in the 1970s, despite a shakeout in the stock
market, because inflation would be raging.

Look for old bankbooks that you may have forgotten about, and that account that you opened with the minimum $100 to get the Free Bonus Digital Doohickey.
◆Checking accounts.
◆Savings certificates or certificates of deposit.
◆ U.S. savings bonds (including that one you got as a graduation gift and have since forgotten).
◆Stocks. List at current market value.
◆Bonds. List at current market value.
◆Mutual funds. List at current market value.
◆Money market funds. List at current market value.
◆Brokerage account credit balance.
◆Life insurance cash value.
Fixed Assets
In listing these, start with the obvious: the market value of your major possessions—e.g., your house, your car (or cars). Contact a realtor for the current market value of your house. Consult the “blue book” (available online or at your library) for the going price on the make, model and year of your car.

◆Easiest availability—directly from the federal government (Treasury Direct) and through most brokers and many banks anywhere in the world.
◆Cheapest availability—no middlemen, no commissions, no loads.
◆Duration—the range of maturities available is extensive; you can buy a note or bond that will mature in a few months or one that won’t come due for thirty years.
◆Absolute stability of income over the long run—ideal for FI. Avoids the income fluctuations that would occur with money market funds, rental real estate, etc.
Treasury Bonds
Treasury bonds are the ideal investment vehicle for FIers with a low risk tolerance because they protect principal, provide a steady stream of income and are relatively easy to understand. In addition, they are exempt from local and state taxes, can be bought and sold almost instantly with minimal handling charges, and are protected by the full faith and trust of the U.S. government.

pages: 419words: 130,627

Last Man Standing: The Ascent of Jamie Dimon and JPMorgan Chase
by
Duff McDonald

It was not sold—it went bust. The world’s stock markets crashed as a result. The Dow Jones fell by 504 points on Monday, September 15. (Barclays later bought a number of Lehman’s assets, but not the entire firm.)
Lehman’s failure set off a chain reaction. Reserve Primary Fund, a $64 billion money market fund that had been heavily invested in Lehman’s debt, broke the buck—its net asset value fell below the crucial level of $1 per share—and nearly collapsed, sparking mass withdrawals. About $500 billion was withdrawn from money market funds in the two weeks that followed Lehman’s collapse. On Tuesday, September 16, the government chose to rescue the insurance giant AIG with an $85 billion loan, just one day after Lehman had been deprived of such largesse. (By April 2009, the total amount thrown at AIG was $162.5 billion and climbing.)

…

It established Dimon as Wall Street’s banker of choice, and buffed JPMorgan Chase’s reputation to such a high shine that the firm was still benefiting a year later, even as its business continued to deteriorate along with the economy. “In the end, it was a tough deal,” recalls the head of asset management, Jes Staley. “With one exception. What it did for our reputation was worth every penny. It was unbelievable. Absolutely.”
The result of this enhanced reputation was tangible. The company had $400 billion in money market funds under management at the end of 2007. It took in another $200 billion in 2008 alone. Other divisions experienced similar gains. JPMorgan Chase’s commercial banking division, for example, saw 2008 net income surge 27 percent to $1.4 billion even as recession gripped the country.
As Bear had proved, reputation is everything on Wall Street. As Bear’s own standing was diminished, Jamie Dimon’s rose to towering heights.

…

By late fall, JPMorgan Chase had $60 billion in the interbank loan market, increased its commercial loan balances by 18 percent through the year’s end, and also increased both student loans and credit card loans. He also repeated, whenever given the chance, that in the era after World War II, banks had accounted for 60 percent of lending in the economy, but by the turn of the twenty-first century that portion had fallen to just 20 percent. The rest was provided by Wall Street and the so-called “shadow banking” industry, which includes hedge funds, money market funds, and creators of securitized debt.
The seizing up of credit that crippled the global economy in 2007 and 2008, in other words, could not be explained simply by saying that a bunch of banks decided to stop lending. According to a study by the consultancy Oliver Wyman, bank lending decreased by $400 billion from 2007 to 2008, while capital markets lending fell by $950 billion. Given that total net bank lending in 2007 was just $850 billion, the study observes, “it is obvious that banks would never be able to make up for the shortfall from capital markets.”

While nothing like the X.com plans for a financial supermarket, this optional service enabled users to earn interest on the balance in their PayPal accounts. Although called the PayPal Money Market Fund, the fund was owned and managed by Barclays Bank, an arrangement which allowed our company to again steer clear of activities that could land us with a commercial bank classification. Sacks hoped that providing our users with an interest-bearing incentive to keep cash in PayPal would decrease their reliance on expensive credit cards to fund payments.
The one-two punch of international accounts and the money market fund didn’t completely repair all the damage that our brand sustained during the upgrade campaign, but it went a long way toward reassuring our customers that we’d continue to innovate and improve our service at a faster rate than Billpoint.

…

Harris bragged to The Wall Street Journal that he had received CEO offers from more than one hundred startups but chose X.com because he saw it as “a blank canvas upon which to write new rules on the delivery of financial services.”2
X.com also generated some additional buzz toward the end of 1999 with a no-fee, no-minimum balance S&P 500 index fund, the only one of its kind.3 This loss leader product had been rationalized as a way to attract new users who could be up-sold to X.com’s other financial products, including its bond and money market funds, interest-bearing checking accounts, and low APR credit lines. X.com certainly seemed eager to become a financial services supermarket, but Confinity had not seen any sign that it held an interest in following PayPal into person-to-person payments.
Yet here it was. Sometime over the previous month, X.com had quietly built an e-mail-based payment feature on top of its existing bank account service and had turned itself into a formidable competitor.

Barry Schwartz writes about this in The Paradox of Choice: Why More Is Less:
. . . As the number of mutual funds in a 401(k) plan offered to employees goes up, the likelihood that they will choose a fund—any fund—goes down. For every 10 funds added to the array of options, the rate of participation drops 2 percent. And for those who do invest, added fund options increase the chances that employees will invest in ultraconservative money-market funds.
You turn on the TV and see ads about stocks, 401(k)s, Roth IRAs, insurance, 529s, and international investing. Where do you start? Are you already too late? What do you do? Too often, the answer is nothing—and doing nothing is the worst choice you can make, especially in your twenties. As the table on the next page shows, investing early is the best thing you can do.
Look carefully at that chart.

…

Well, the companies that offer 401(k)s take this to an extreme: They offer a few investment funds for you to choose from—usually the options are called something like aggressive investments (which will be a fund of mostly stocks), balanced investments (this fund will contain stocks and bonds), and conservative investments (a more conservative mix of mostly bonds).
If you’re not sure what the different choices mean, ask your HR representative for a sheet describing the differences in funds. Note: Stay away from “money market funds,” which is just another way of saying your money is sitting, uninvested, in cash. You want to get your money working for you.
As a young person, I encourage you to pick the most aggressive fund they offer that you’re comfortable with. As you know, the more aggressive you are when younger, the more money you’ll likely have later. This is especially important for a 401(k), which is an ultra-long-term investment account.

As credit markets reflated, Maiden Lane recovered sufficient value and income from those assets to pay down the debt—and turn a profit for the Federal Reserve. By the end of 2011 the $30 billion loan had been reduced to $4 billion, and Maiden Lane still had assets worth about $7.2 billion.
The week that Lehman Brothers failed, the Treasury Department started a program to guarantee the $3.4 trillion money market fund industry. It collected $1.2 billion in fees from operators of money market funds and didn’t pay a single claim before the guarantee was lifted in September 2009. In November 2008 the Federal Deposit Insurance Corporation, an independent agency ultimately backstopped by taxpayers, threw a huge lifeline to the banking industry by offering to guarantee the debt of financial services companies—for a fee. Banks took advantage of the low rates and quickly issued more than $313 billion in debt under the Temporary Liquidity Guarantee Program.

The problem, emphasized in Princeton professor Steve Goldfeld’s 1976 paper “The Case of the Missing Money” was not hard to ascertain.12 Thanks to a mix of new technologies (the growth of credit cards), financial liberalization (particularly the end of restrictions on the interest rates banks could pay), and deregulation that created new instruments like money market funds, the relationship between Friedman’s notion of “money” and inflation began to fray badly. For a time, the Federal Reserve tried to find a link between money and prices by developing ever more expansive measures of “money,” for example, incorporating money market funds in addition to checking and savings accounts, with the aim of trying to find some notion of money that still had a stable reliable relationship with the price level. But such efforts were largely to no avail.
In the event, Friedman’s measure of money grew far more slowly at times than inflation, because as the economy adjusted to new technologies, it simply was not necessary to have as much currency (or any form of older payment technology, e.g., checking accounts) to achieve the same level of transactions.

…

Even if paper money revenue disappeared completely, the central bank would still earn money from electronic bank reserves, with the exact profits depending on the interest rate paid to banks relative to the interest rate the central bank earns on its assets. One imagines that in a fully electronic world (with all low-income individuals receiving heavily subsidized debit accounts), demand for reserves at the central bank would rise, potentially quite sharply. And this process is hardly exogenous. The government has numerous regulatory levers it can pull, for example, taking more forceful steps than it has in the past to pull the plug on money market funds, which in the current environment remain a regulatory end-around.
In the extreme case, the government could adopt a version of the 1930s “Chicago plan,” which would essentially allow banks to issue money-like instruments only if they were 100% backed by government debt, which presumably can include central bank reserves.10 The name relates to Chicago economists Henry Simon, Frank Knight, Milton Friedman, and Irving Fisher (the last actually a Yale professor), who advocated the idea of “narrow banking” to mitigate moral hazard problems and eliminate bank runs (assuming that the government itself is fully solvent).

That fact alone was enough to make everyone wonder at once how much more of this stuff was out there, and who owned it.
The Fed and the Treasury were doing their best to calm investors, but on Wednesday no one was obviously calm. A money market fund called the Reserve Primary Fund announced that it had lost enough on short-term loans to Lehman Brothers that its investors were not likely to get all their money back, and froze redemptions. Money markets weren't cash--they paid interest, and thus bore risk--but, until that moment, people thought of them as cash. You couldn't even trust your own cash. All over the world corporations began to yank their money out of money market funds, and short-term interest rates spiked as they had never before spiked. The Dow Jones Industrial Average had fallen 449 points, to its lowest level in four years, and most of the market-moving news was coming not from the private sector but from government officials.

…

Only the ardor of the Wall Street firms, desperate to buy fire insurance on their burning home, remained undimmed. "It's the first time we're seeing any prices that reflect anything close to like what they're really worth," said Charlie. "We had positions that were being valued by Bear Stearns at six hundred grand that went to six million the next day."
By eleven o clock Thursday night Ben was finished. It was August 9, the same day that the French bank BNP announced that investors in their money market funds would be prevented from withdrawing their savings because of problems with U.S. subprime mortgages. Ben, Charlie, and Jamie were not clear on why three-quarters of their bets had been bought by a Swiss bank. The letters U B S had scarcely been mentioned inside Cornwall Capital until the bank had started begging them to sell them what was now very high-priced subprime insurance. "I had no particular reason to think UBS was even in the subprime business," said Charlie.

Since 1900, U.S. banks have tripled their leverage from around four to twelve; they have taken more liquidity risk by using short-term borrowing to purchase long-term assets; and they have focused more of their resources on high-risk proprietary trading.5 The 2007–2009 crisis, in which governments extended the reach of deposit insurance, guaranteed savings held in supposedly uninsured money-market funds, and bent over backward to pump emergency liquidity into all corners of the markets, is likely to induce even more recklessness in the future. Put simply, government actions have decreased the cost of risk for too-big-to-fail players; the result will be more risk taking. The vicious cycle will go on until governments are bankrupt.
There are two standard responses to this scary prospect. The first is to argue that governments should not bail out insurers, investment banks, money-market funds, and all the rest: If financiers were made to pay for their own risks, they would behave more prudently. For example, if investors had been forced to absorb the cost of the Bear Stearns bankruptcy in early 2008, rather than having the blow softened by a Fed-subsidized rescue, they might have prepared themselves better to absorb the costs of Lehman’s failure some months later.

…

The clearest problem is “too big to fail”—Wall Street behemoths load up on risk because they expect taxpayers to bail them out, and other market players are happy to abet this recklessness because they also believe in the government backstop. But this too-big-to-fail problem exists primarily at institutions that the government has actually rescued: commercial banks such as Citigroup; former investment banks such as Goldman Sachs and Morgan Stanley; insurers such as AIG; the money-market funds that received an emergency government guarantee at the height of the crisis. By contrast, hedge funds made it through the mayhem without receiving any direct taxpayer assistance: There is no precedent that says that the government stands behind them. Even when Long-Term Capital collapsed in 1998, the Fed oversaw its burial but provided no money to cover its losses. At some point in the future, a supersized hedge fund may prove to be too big to fail, which is why the largest and most leveraged should be subject to regulation.

…

The next day President Bush visited the Treasury to meet with his economic advisers. “[I]f the market functions normally, it will lead to a soft landing,” he said hopefully. On Thursday the tone from Washington began to change, but less because of the carnage at quantitative funds than because of trouble from Europe: The giant French bank BNP Paribas had suspended redemptions from three internal money-market funds, citing “the complete evaporation of liquidity.” Subprime losses were clearly scaring the markets, and the European Central Bank responded with $131 billion in emergency liquidity. By Thursday afternoon, the Fed’s chairman, Ben Bernanke, had turned his office into a makeshift war room, and his chief lieutenants dialed in from various vacation locations. Early the next morning, the Fed reversed its earlier emphasis on inflation, pledging to provide enough cash “to facilitate the orderly functioning of financial markets.”

The Treasury announced a rescue package for AIG this morning, but unexpected cracks from the impact of Lehman Brothers’ collapse are showing up elsewhere. Today, The Reserve fund, the nation’s oldest money market fund, “breaks the buck” by reporting a net asset value of less than a dollar a share. The news feeds the growing panic. If this financial crisis can infect even supposedly secure money funds, for decades the middle-class substitute for a bank account, there is no safe haven.
At Fairfield Greenwich Group, whose wealthy investors have long thought of Madoff as a sort of plutocratic money market fund, clients are seeking clarity and comfort.
Today the group sends out a reassuring “Dear Investor” letter from Amit Vijayvergiya, the chief risk officer. He quickly mentions that the Sentry fund has no exposure to Lehman, Bank of America, or Merrill Lynch.

…

The financial system is already reeling with bankruptcies and bailouts. The year 2008 challenges 1929 as the most frightening and frenzied in the long history of Wall Street. The Bear Stearns brokerage house has failed. Fannie Mae and Freddie Mac, two US government-sponsored mortgage giants, have been bailed out; the venerable Lehman Brothers firm wasn’t. Within a day of Lehman’s bankruptcy, the nation’s oldest money market fund was swept away by a tsunami of panicky withdrawals. Before that day ended, regulators were scrambling to rescue the insurance giant AIG, fearing that another titanic failure would shatter whatever trust continued to hold the fragile financial system together.
People are already furious, shaking their fists at the arrogant plutocrats who led them into this mess.
Then, in a camera flash, Bernie Madoff is transformed from someone whom no one but Wall Street insiders and friends would recognize into a man who is headline news around the world.

…

It didn’t seem possible for this rule to have been so widely and so catastrophically ignored, even by nonprofit trustees and pension plans with fiduciary obligations. Typically, the failure of a legitimate midsize brokerage firm like Madoff’s would not wipe out every single penny its customers had. Plenty—or, at least, something—would be left in a company pension plan or a bank account or a money market fund. As for the hedge funds, they supposedly catered only to wealthy, sophisticated people who were, by definition, too smart to hazard their entire fortune on one investment. Indeed, this had been one of the reasons for not regulating hedge funds more tightly over the years.
Fires, earthquakes, and hurricanes were readily recognized as events that required an emergency response to alleviate human suffering; the Madoff fraud was not.

But as far as the economics are concerned, a bank is any institution that borrows short and lends long, that promises people easy access to their funds, even as it uses most of those funds to make investments that can’t be converted into cash at short notice. Depository institutions—big marble buildings with rows of tellers—are the traditional way to pull this off. But there are other ways to do it.
One obvious example is money market funds, which don’t have a physical presence like banks and don’t provide literal cash (green pieces of paper bearing portraits of dead presidents), but otherwise function a lot like checking accounts. Businesses looking for a place to park their cash often turn to “repo,” in which borrowers like Lehman Brothers borrow money for very short periods—often just overnight—using assets like mortgage-backed securities as collateral; they use the money thus raised to buy even more of these assets.

On Tuesday, September 16, the Reserve Primary Fund, a big money market mutual fund that had bought more than $700 million in short-term debt issued by Lehman, which was now worthless, announced that its customers would no longer be allowed to withdraw cash from their accounts because it didn’t have enough to pay them all: its net asset value had fallen below a dollar a share. Since the founding of the first money market fund in 1970, only one other fund had “broken the buck.” Fearing that other firms would find themselves in a similar position to the Reserve Primary Fund, private and institutional investors began pulling their money out of money market funds, raising the possibility of a full-scale run on the industry. In just a few days, almost $150 billion was withdrawn.
This was a truly alarming development, and not just for the mutual fund industry. With about $3.5 trillion in assets, money market funds are major players in the financial system. Through investing in commercial paper and other short-term debts, they provide day-to-day funding for many financial and nonfinancial firms.

Bank chiefs and financial regulators are currently working with a strategy that can be summarized as eyes shut and fingers crossed.
These things haven’t exactly escaped the attention of the financial markets. All through 2011 there’s been a growing sense of jitteriness‌—‌mirroring to an uncanny degree the anxiety felt in the months between the collapse of Bear Stearns and the Lehman bankruptcy. That nervousness has manifested itself in an acute risk-aversion. American money market funds are pulling their cash out of Europe. Interbank loans have become ever shorter in duration, meaning that ever larger volumes of money have to roll over every week. French banks, indeed, have effectively lost their access to this market. And these things matter. As so often in this book, I find myself making statements that sound boringly technical. European bank funding is becoming more short-term: I mean, do you really care?

…

But these things are likely to affect you personally, and massively. Your job, your pension, your savings, your government may come to depend on these things.
The disaster scenario is this. A big bank‌—‌let’s say a mythical French one, the Banque des Grandes Baguettes (BGB)‌—‌announces unexpectedly large losses on its sovereign loan portfolio. It has become highly reliant on short-term funding, but money market funds and the interbank market now cut it off completely. BGB is now totally reliant on funding from the European Central Bank, and the ECB in turn comes under acute pressure to force a restructuring or bankruptcy filing. Maybe the ECB caves into that pressure, maybe it doesn’t, but either way the market is in a panic. In Italy, the Banco Bunga Bunga announces that it too has lost the ability to fund itself.

…

If you don’t understand something, don’t invest in it. It’s a rule that has protected me for thirty years. It’s a rule I urge you to follow yourself.
That said, the first and biggest moral of this book is that you need to throw out all the assumptions you’ll have lived with to this point. Sovereign debt is no longer so safe you don’t have to think about it. (Truth is, it never was.) Banks might fail, including large ones. Money market funds may ‘break the buck’‌—‌that is, lose money. Equally, you need to shed some of your Ponzi-ish optimism. House prices have fallen, but they may fall further. Stock market prices have fallen, but they may fall further. Some bond prices have already collapsed, but they could collapse further. The dollar has collapsed against the yen (falling by a third, from $1 = ¥120 in 2007 to less than ¥80 at the time of writing).

In this case, the foreign-currency-denominated feeder funds have a currency hedge in addition to their investment into the master fund. Another use of this structure is to have feeder funds at different risk levels. If the master fund has a volatility of 20% per year, one feeder fund might have the same volatility while another has half the volatility. The lower-risk feeder simply invests half its capital in a money market fund and the other half into the master fund, thus realizing half the risk.
Figure 1.1. The master–feeder hedge fund structure.
The master fund has a pool of money, and this is where all the trades are carried out. It has an investment management agreement (IMA) with the management company to provide investment services, including strategy development, implementation, and trading. Hence, the management company is where all the employees work—including the traders, research analysts, operations staff, business development people, compliance, and legal personnel—and the management company is owned by the hedge fund managers.

…

The securities that a hedge fund has sold short are liabilities (since the hedge fund eventually needs to return these shares). The cash proceeds from the sale are assets, but they are held as collateral by the securities lender. In addition, the securities lender requires additional cash as margin requirement and, hence, the hedge fund must use equity capital “supporting margin requirements for short positions.”
Lastly, the hedge fund has additional equity invested in cash instruments (e.g., money market funds, Treasury bills, or margin excess with prime brokers), as seen in the balance sheet. This additional equity makes it able to sustain losses without having to immediately liquidate positions.
Hedge funds also gain economic leverage by using derivatives and, though this economic leverage may not formally show up on the balance sheet, their notional exposures should also be considered when leverage is estimated.

…

Receiving a margin call is itself a negative. Even if the hedge fund successfully adds cash, repeated margin calls are a sign of problems and can eventually lead the prime broker to terminate the arrangement or increase margin requirements. Hence, hedge funds naturally try to keep excess margin capital. (Some hedge funds have all their capital in their margin account, while others have most of their cash in a money market fund, moving it into the margin account as needed.)
The overall economics of funding a portfolio are quite general, but the specific institutional arrangements depend on the type of security. Let us briefly review the main forms of leverage, that is, the main ways that the overall economic principles discussed are put into practice.
• Repo. Government bonds and other fixed-income securities are usually leveraged using what is called a repurchase agreement, or repo for short.

Reluctantly, they began to show interest in converting the abstract ideas of the academics into methods to control risk and to staunch the losses their clients were suffering. This was the motivating force of the revolution that shaped the new Wall Street.
•••
Even an incomplete list of the innovations that have emerged since the mid-1970s reminds us of how profoundly the present differs from the past. The unfamiliarity of some of the new terminology suggests the magnitude of that break with tradition.
Today there are money market funds, bank CDs for small savers, unregulated brokerage commissions, and discount brokers. There are hundreds of mutual funds specializing in big stocks, small stocks, emerging growth stocks, Treasury bonds, junk bonds, index funds, government-guaranteed mortgages, and international stocks and bonds from all around the world. There is ERISA to regulate corporate pension funds, and there are employee savings plans that enable employees to manage their own pension funds.

…

Errors shrank from 5 percent to less than 0.1 percent, and the necessary number of transactions held to acceptable levels. The first sales material for Leland-Rubinstein’s portfolio insurance product contained an example of protection against five market moves of 5 percent, with the protection in force until the maximum number of moves had taken place.
Rubinstein set out to prove to the world that this splendid product really worked: he tried it out with his own money, shifting between a money market fund and a mutual fund that tracked the S&P 500 Index over a period of six months. Everything worked out exactly as expected. The experiment was so successful that Fortune magazine published an article about it.
Marketing began in earnest in 1979. Armed with a letter from Barr Rosenberg endorsing the validity of the principles behind the product, Leland visited a number of bank trust departments in the East and Midwest, including Morgan Guaranty in New York and American National Bank in Chicago.

Regulating Regulation
The period after the crisis has been rife with regulation as bank and market-focused rules
have been/are in the process of being implemented, notably in the US and in the EU, e.g.,
Dodd-Frank Act (2010), Volker Rule (2013), Third Basel Accord (2013), EU Commission’s
Liikanen proposals (2012), European Market Infrastructure Regulation (EMIR) (2012),
etc.… These regulations target liquidity and collateral requirements, money market
funds, taxation, derivatives, and consumer protection rights, among others. As the scope
of regulation is large, we will focus on the concept and role of regulation in the context
of market players rather than entering the intricacies of specific regulations on different
sectors.
Markets are often cited to be the whipping boys of regulation. Time and time again,
terms such as “stifling regulation” or “excessive regulation” are cited by the media as
impediments to innovation and economic growth, and regulators are portrayed to be
“asleep at the wheel” or detached or aloof from the markets that are in their supervisory
charge.

Paul Asquith, a professor at Harvard Graduate School of Business, with his colleagues David Mullins and Eric Wolf, found that junk bond default rates were higher than previously stated. Around 30 percent of all junk bonds issued in 1977–9 had defaulted or been subject to a distressed exchange. Lipper Analytical Services, an investment firm, found that over 10 years junk bonds provided lower returns than government bonds, earning the same as money market funds. Altman published new research reaching similar conclusions.26 As Laurence J. Peter, author of The Peter Principle, stated: “Facts are stubborn things, but statistics are more pliable.”
Fallen Angels
Milken put Hickman’s theories to work at Drexel Harriman Ripley, an investment bank that had once partnered with JP Morgan. As head of fixed income research and subsequently sales and trading, Milken operated in the bond underworld, buying and selling fallen angels or Chinese paper—bonds issued by investment-grade companies that had their ratings downgraded and were trading at deep discounts.

…

Issued by a Cayman Islands’ SPV, Lehman Brothers’ Minibonds were marketed as simple bonds paying a high interest rate. In fact, they were complex, highly financially engineered derivatives, where the higher return required taking the risk that none of seven or eight companies would default or file for bankruptcy.
The SPV invested the money subscribed by investors in high-quality AAA-rated securities, initially investments in money market funds. The investments secured a credit derivative known as a first-to-default (FtD) swap. The investors received an annual fee that together with the interest on the money invested gave the investors the higher return. The investors agreed to make a contingent payment if any one of the identified firms defaulted. Under the FtD swap, the investors were exposed to all seven or eight entities, although the loss was limited to the first entity to default and the face value of the Minibonds.

…

If the default correlation is 0, then the FtD is equivalent to selling insurance on all the entities within the basket with a limit on the maximum loss. Assuming low or zero default correlation, the risk of any one entity within a basket of eight well-rated firms defaulting is significantly higher than for any single entity defaulting. A FtD basket based on investment grade companies may be equivalent to noninvestment grade credit risk.
Over time, instead of placing the investor’s money in money market funds, the cash was invested in CDOs and CDO2s, arranged and sold by Lehman, adding to the risk of the arrangements.
In Hong Kong, in accordance with local superstitions, no series of Minibonds were issued with the number 4, considered unlucky in Chinese culture. Advertisements and flyers prominently featured symbols of potency, luck or profit—tigers, rhinoceroses, and whales. Investors were enticed with prizes, including video cameras and flat-screen televisions.

In this section we will focus first on the banks.
Money Supply without Money Demand
That most money today is produced by banks can easily be ascertained by a look at Federal Reserve statistics. The Fed’s money supply measure M2 includes currency in circulation, demand deposits at banks, various time deposits, money market funds, and a few other items. All of these constitute what is used as money in the United States today. Of the 8.8 trillion dollars in M2, about 915 billion are dollar notes and coins and about 700 billion are money market funds (as of December 2010). The rest are demand deposits and various time or saving deposits at banks. In short, about 80 percent of what is money according to Federal Reserve definition is a balance sheet item at a bank.
The general public does often not appreciate that this is money that the banks create.

A torrent of funds — a “Giant Pool of Money” doubling in size between 2000 and 2007 — was flowing into US financial markets.5 While foreign governments were purchasing risk-free US Treasury bonds, thus avoiding much of the impact of the eventual crash, other overseas investors, including pension funds, were gorging on the higher yielding mortgage-backed securities (MBSs) and CDOs. The indirect consequences were that US households were in effect using funds borrowed from foreigners to finance consumption or to bid up house prices, while sales of mortgage-backed securities also amounted to sales of accumulated wealth to foreign investors.
Shadow Banks and the Housing Bubble
By this time a largely unregulated “shadow banking system,” made up of hedge funds, money market funds, investment banks, pension funds, and other lightly-regulated entities, had become critical to the credit markets and was underpinning the financial system as a whole. But the shadow “banks” tended to borrow short-term in liquid markets to purchase long-term, illiquid, and risky assets, profiting on the difference between lower short-term rates and higher long-term rates. This meant that any disruption in credit markets would result in rapid deleveraging, forcing these entities to sell long-term assets (such as mortgage-backed securities) at depressed prices.

…

During the past three years, the Fed’s balance sheet has swollen to more than $2 trillion through its buying of bank and government debt. Actual expenditures included $29 billion for the Bear Stearns bailout; $149.7 billion to buy debt from Fannie Mae and Freddie Mac; $775.6 billion to buy mortgage-backed securities, also from Fannie and Freddie; and $109.5 billion to buy hard-to-sell assets (including MBSs) from banks. However, the Fed committed itself to trillions more in insuring banks against losses, loaning to money market funds, and loaning to banks to purchase commercial paper. Altogether, these outlays and commitments totaled a minimum of $6.4 trillion.
Documents released by the Fed on December 1, 2010 showed that more than $9 trillion in total had been supplied to Wall Street firms, commercial banks, foreign banks, and corporations, with Citigroup, Morgan Stanley, and Merrill Lynch borrowing sums that cumulatively totaled over $6 trillion.

In fact, the dark side did contribute to the bubble and the subsequent crisis, but it’s also precisely the side that is most promoted, subsidized, and protected by government. A number of books have been written on this subject, dramatizing the many poor decisions made by bankers in the shadow banking system, but none that I know of seem able (or willing) to pinpoint the real root of the trouble.
The shadow banking system mainly consists of nondepository banks and financial firms—like hedge funds, money market funds, investment banks, and insurers—which grew enormously in the past decade and came to play an increasingly important role in lending to businesses, distributing securities, and insuring debts. By 2008, some estimates of the size of this shadow banking system placed it on a par with the more traditional deposit-based banking system. By one account, in 2007, the system was “built on derivatives and untouched by regulation.”1
However, because of their complexity, the role of these instruments has been both misunderstood and significantly overestimated.

…

Since the early 1970s, regulated financial institutions have faced dramatically increased costs on a multitude of “politically correct” fronts. These costs have driven commercial banks to focus on areas with higher levels of profits, such as real estate lending, which can also be more risky.
Another factor has been the disintermediation of deposits caused by money market mutual funds. These funds often pay higher interest rates on deposits than banks pay. The money market funds also claimed to be as low risk as bank certificates of deposit. Of course, when the financial crisis started, many money funds were under water because in fact they had taken more risk. Unfortunately, the Federal Reserve chose to save the money funds, which created an illusion that they are not risky. Banks have been paying FDIC insurance premiums since 1933. The money funds got the benefit of a Federal Reserve bailout without having to buy insurance in advance.

Numerous experiments are currently under way, including bilateral swaps between the Chinese central bank and foreign central banks (one side of which is RMB), and reciprocal invoicing of trade transactions between a number of partner economies and the People’s Republic of China (again involving RMB).
But the main test-bed for gradual liberalization of the RMB is Hong Kong. For several years Hong Kong residents have been able to accumulate RMB deposits (at a limited rate), and since July 2010 several RMB investment products such as RMB-denominated bonds or money market funds have become available in the territory. Also since July 2010 Hong Kong banks have been allowed to offer settlement facilities for trade transactions (but not capital transactions) denominated in RMB, together with limited deposit and lending facilities. For example, loans to companies–whether resident in Hong Kong or not–are permitted if related to trade transactions, but not loans to individuals.

…

It examines the role of the brain when humans evaluate choices, interact with other humans, and evaluate risks and rewards.
NEUROPLASTICITY: The brain’s ability to reorganize itself through the formation of new neural connections in response to new situations and environmental changes throughout life.
OUTPUT GAP: The difference between actual and potential output as a percent of GDP.
OVERNIGHT RATE: The interest rate on money market funds that are lent and borrowed overnight.
PALACE COUP: An overthrow of or challenge to a sovereign or other leader by members of the ruling family or group.
PATRONAGE SYSTEM: The postelection practice in which loyal supporters of a winning candidate and/or party are rewarded with appointive public offices.
PERESTROIKA: Policies instituted by Mikhail Gorbachev in the 1980s that brought about governmental and economic reforms.

Over the years Quinn made numerous enemies, ranging from brokers to heads of mutual fund companies, for relentlessly putting the financial interests of the consumer ahead of the financial interests of the financial services industry. Quinn sees herself as both a part of the consumer movement and the personal finance and investment communities. She names as her contemporaries such financial pioneers as Bruce Bent, the creator of the now ubiquitous money market fund, and John Bogle, the force behind Vanguard’s low-cost index funds.
Yet a look at Quinn’s work demonstrates both the promise and the perils of the financial advice arena. A quick run through the many, many profiles of her penned over the years shows howlers mixed in with the prescient comments, sometimes in the same piece, proving how hard it is to get this forecasting thing right. In a USA Today interview in 1991, for example, she opines “You can no longer count on your real estate to make you rich,” a statement that was objectively untrue, at least at that time.

…

The coalescing of several trends in American life ensured the personal finance industrial complex would keep growing. First, the pace of financial innovation was increasing, and, as a result, our fiscal lives were becoming more complicated. When Quinn joined McGraw Hill in the late 1960s, credit cards had existed for a little more than a decade. There were no adjustable rate mortgages, home equity loans, money market funds, discount brokerages, day traders, IRAs, or other direct contribution retirement accounts like the 401(k). As these innovations debuted in the marketplace over the course of the 1970s and 1980s, the need for financial information grew exponentially.
Second was the great bull market of the twentieth century, which began just as Americans were beginning to grapple with self-funded retirement mechanisms like the IRA and 401(k).

If equity is issued, the value of each share falls, so there is a limit at which equity issuance becomes self-defeating. Raising deposits, especially in an economy in which savings rates are falling, also has limits. Debt has no such limit.
So where could European banks find huge amounts of cheap debt to fund themselves? The repo markets we encountered in chapter 2 were one place, but this time they were located in London rather than New York.60 US money-market funds that were looking for positive returns in a low-interest-rate world after 2008 was the other. After all, those conservative European banks were nowhere near as risky as those US banks, so why not buy lots of their short-term debt? The ECB will never let them fail, right?
As the 2000s progressed, those supposedly conservative European banks increasingly switched out of safe, local, deposit funding and loaded up on as much short-term internationally sourced debt as they could find.

…

So much so that according to one study, by “September 2009, the United States hosted the branches of 161 foreign banks who collectively raised over $1 trillion dollars’ worth of wholesale bank funding, of which $645 billion was channeled for use by their headquarters.”61 US banks at this time sourced about 50 percent of their funding from deposits, whereas for French and British banks the comparable figure was less than 25 percent.62 By June 2011, $755 billion of the $1.66 trillion dollars in US money-market funds was held in the form of short-term European bank debt, with over $200 billion issued by French banks alone.63 Just as in 2008, these banks were borrowing overnight to fund loans over much longer periods.
Besides being funded via short-term borrowing on US markets, it turned out that those conservative, risk-averse European banks hadn’t missed the US mortgage crisis after all. In fact, over 70 percent of the SPVs set up to deal in US “asset backed commercial paper” (mortgages) we encountered in chapter 2 were set up by European banks.64 The year 2008 may have been a crisis in the US mortgage markets, but it had European funders and channels, and most of those devalued assets remain stuck on the balance sheets of European banks domiciled in states with no printing presses.

Secretary Paulson, whose antipathy to Lehman’s CEO since his days at Goldman Sachs is well documented, says a rare ‘No’. Lehman Brothers thus files for bankruptcy, initiating the crisis’s most dangerous avalanche.
Monday, 15 September 2008: the day Lehman Brothers dies. Lehman’s has been one of the main generators of CDOs. An independent money market fund holds Lehman CDOs and, since it has no reserves, it must stop redeeming its shares. Depositors panic. By Thursday a run on money market funds is in full swing.
In the meantime, Merrill Lynch, which finds itself in a similar position, manages to negotiate its takeover by Bank of America at $50 billion, again with the taxpayer’s generous assistance – assistance that is provided by a panicking government, following the dismal effects on the world’s financial sector of its refusal to rescue Lehman Brothers.

Staying behind as one of the only remaining members of the President’s original White House inner circle was his longtime friend from Chicago Valerie Jarrett. Before coming to the White House, Jarrett had been CEO of the property management firm Habitat Co., which had earned millions off government contracts developing low-income housing to replace the dismantled Chicago Housing Authority projects. When entering office, she reported a money market fund that held between $1 million and $5 million.
The point is this: The 1 percent and the nation’s governing class are more or less one and the same. If you are a member of the governing elite and aren’t a millionaire, you’re doing something wrong. And if the divide between the 1 percent and the 99 percent really is a defining feature of our politics, how can the 99 percent trust that same wealthy, governing elite to zealously pursue its interests?

…

Galbraith, “Inequality, Unemployment, and Growth: New Measures for Old Controversies,”
UTIP Working Paper no. 48, p. 39, http://utip.gov.utexas.edu/papers/utip_48.pdf, accessed February 23, 2012.
25 “They’ll say to you”: Author interview.
26 nearly half of all members of Congress have a net worth north of a million dollars: See Eric Lichtblau, “Economic Downturn Took a Detour on Capitol Hill,” New York Times, December 26, 2011, and Peter Whoriskey, “Growing Wealth Widens Distance between Lawmakers and Constituents,” Washington Post, December 26, 2011.
27 According to an August 2010 study: See pp. 5–6 of Jordi Blanes i Vidal, Mirko Draca, and Christian Fons-Rosen, “Revolving Door Lobbyists,” Centre for Economic Performance: London School of Economics, http://cep.lse.ac.uk/pubs/download/dp0993.pdf, accessed April 5, 2012.
28 “A telegenic young lawmaker with a wide network of relationships”: Michael Barbaro and Louise Story, “Merrill Lynch Guaranteed Ford Annual Pay of at Least $2 Million,” New York Times, February 25, 2010.
29 Sarah Palin … made a reported $12 million: See Matthew Mosk, “Sarah Palin Has Earned an Estimated $12 Million Since July,” ABC News, April 23, 2010.
30 Rahm Emanuel … amassed a fortune of more than $18 million: See Michael Luo, “In Banking, Emanuel Made Money and Connections,” New York Times, December 3, 2008.
31 Jack Lew, who spent four years at Citigroup and received a bonus of $950,000 in 2009: Cited in Daniel Halper, “New Chief of Staff: Former Hedge Fund Exec. at Citigroup, Made Money Off Mortgage Defaults,” Weekly Standard, January 9, 2012.
32 that gig paid him $5.2 million a year, or more than $100,000 per week, for one day of work a week: Cited in Louise Story, “U.S. Economy Chief Had Inside View of Wall Street,” International Herald-Tribune, April 7, 2009.
33 Axelrod reported income of $1.5 million: Cited in “All the President’s Millionaires: Disclosure Reports Show That Many in Barack Obama’s Inner Circle Have More Than Just a City in Common,” Chicago Tribune, April 9, 2009.
34 Valerie Jarrett … reported a money market fund that held between $1 million and $5 million: See “White House Wealth: President Barack Obama’s Team Virtually All Chicago Millionaires,” Chicago Tribune, April 9, 2009.
35 “Even the supporters of apartheid were the victims of the vicious system”: Desmond Tutu, No Future Without Forgiveness (New York: Doubleday, 1999), p. 103.
36 “The point about Davos is that it makes everyone feel wildly insecure”: Anya Schiffrin, “Jealous Davos Mistresses,” Reuters, January 25, 2011.
37 “You have met the phenomenon of an Inner Ring”: See C.

Here we have to pause briefly to explain something about these rate cuts. When the Fed cuts the funds rate, it affects interest rates across the board. So when Greenspan cut rates for five consecutive years, it caused rates for bank savings, CDs, commercial bonds, and T-bills to drop as well.
Now all of a sudden you have a massive number of baby boomers approaching retirement age, and they see that all the billions they have tied up in CDs, money market funds, and other nest-egg investments are losing yields. Meanwhile Wall Street was taking that five consecutive years of easy money and investing it in stocks to lay the foundation for Greenspan’s first bubble, the stock market mania of the nineties.
Baby boomers and institutional investors like pension funds and unions were presented with a simple choice: get into the rising yields of the stock market or stick with the declining yields of safer investments and get hammered.

…

In testimony before the Senate on May 27, 1994, he said:
Lured by consistently high returns in capital markets, people exhibited increasing willingness to take on market risk by extending the maturity of their investments … In 1993 alone, $281 billion moved into [stock and bond mutual funds], representing the lion’s share of net investment in the U.S. bond and stock markets. A significant portion of the investments in longer-term mutual funds undoubtedly was diverted from deposits, money market funds, and other short-term lower-yielding, but less speculative investments.
So Greenspan was aware that his policies were luring ordinary people into the riskier investments of the stock market, which by 1994 was already becoming overvalued, exhibiting some characteristics of a bubble. But he was reluctant to slow the bubble by raising rates or increasing margin requirements, because … why?

But if the mortgages, or at least their riskier subprime tranches, carry very high risk, one may ask the natural question: who would buy them? It turns out that once the mortgages were put into packages, a financial miracle occurred. They were taken to rating agencies, who often put their stamp of approval on them. The subprime packages were in fact rated very highly—80% AAA and 95% A or higher. These ratings were in fact so high that they would be bought into by bank holding companies, money market funds, insurance companies, and sometimes even depository banks themselves that would never have touched any of these mortgages individually.
According to Charles Calomiris, two bits of magic enabled the rating agencies to accomplish this hat trick. They attached to the securities a very low expected loss rate due to default, about 6%. This probability of default was based on very recent data, from a period when housing prices had been rapidly rising.

…

Josepha buys. But she does not know what she is buying. As the pundits and the politicians—and also the economists—have adopted an increasingly uncritical view of capitalism, a whole industry has arisen to produce and sell questionable financial products. For the most part, Josepha herself has not bought these. Instead she has empowered those who control her pension funds, her 401(k) account, her money market fund, or, if she is very rich, her hedge fund managers to buy these products. There has been financial gain for those who trade on behalf of these funds—often very significant gain. But poor Josepha has been left holding the bag.
Our worry, however, is not just for Josepha. This is a book about macroeconomics. Our worry is that when Josepha is left holding the bag, there is a loss of confidence in markets more generally, and a serious recession will follow.

This intermediation has created access to capital and opportunities for millions of people, especially those from lower- and middle-class income backgrounds. Moreover, these institutions provide payment systems, without which our highly interconnected world would likely come to a grinding halt.
The shadow banking system—financial intermediaries that do not have a banking license, such as investment banks, hedge funds, and money market funds—provides a variety of financial services. Financial regulators safeguard the system. Central banks are in charge of monetary policies. Think tanks develop new perspectives, offer expert advice, and advocate special interests. Academics and thought leaders provide innovative views and substantiate or invalidate practices in the financial system.
Leaders of financial firms impact the economy in any number of ways.

…

Rather, they invest on their clients’ behalf, render investment advice, and engage in corporate transactions such as mergers, acquisitions, and initial public offerings. Their deals are usually a bit riskier because they deal with sophisticated clients.
Shadow banks is a catchall term for all financial service providers that lack a banking license, such as investment banks, broker dealers, investment funds, and money market funds. Shadow banks have recently come into focus as much business has fled from heavily regulated banks to the lightly regulated and nimbler shadow banks. In fact, they have received such large capital inflows that they are now considered a potential risk for financial stability.
Bank CEOs are amongst the most powerful individuals in the financial system due to the indispensability and pervasive power of their institutions.

pages: 346words: 90,371

Rethinking the Economics of Land and Housing
by
Josh Ryan-Collins,
Toby Lloyd,
Laurie Macfarlane,
John Muellbauer

This was achieved via ‘securitising’ the loans – packaging loans of different riskiness together to form mortgage-backed securities attractive to a range of different investors.
In 2001, Northern Rock set up ‘Granite’, a securitisation vehicle, to hold and sell these mortgage securities to investors. Unlike deposits, however, this money-market funding was more short-termist and flighty. When the US subprime mortgage crisis struck in 2007, this source of money-market funding suddenly dried up. Banks and other providers of liquidity were suddenly no longer prepared to roll over existing wholesale funding as trust between financial institutions collapsed. Because of its heavy money-market exposure, Northern Rock swiftly ran in to a liquidity crisis. By 14 September 2007, queues were forming outside its doors as people sought to withdraw their deposits: a full-on bank run.

It would unnecessarily impinge on derivative trading (the lucrative practice of making bets on bets) and hedging (using some bets to offset the risks of other bets).
Dimon argued the financial system could be trusted, that the near meltdown of 2008 was a perfect storm that would never happen again. “Most of the bad actors are gone,” he said. “Off-balance-sheet businesses are virtually obliterated,” “money market funds are far more transparent,” and “most very exotic derivatives are gone.” JPMorgan’s lobbyists and lawyers then did everything in their power to eviscerate the Volcker Rule—creating exceptions, exemptions, and loopholes that effectively allow any big bank to go on doing most of the derivative trading it was doing before the near meltdown. By the time of Dimon’s announcement of JPMorgan’s trading losses, the rule had morphed into almost three hundred pages of regulatory mumbo jumbo and still hadn’t been finalized.

The bigger the amount, the better Gary was going to like it.
Would he give me leads?
“Nah.”
Would I get lists of the right kind of people?
“Forget that. Get your own lists.”
How about a desk in his office, where I could answer the phone and pick up a few leads that way?
“Larry, you get a desk and a phone in the bullpen. We’ll teach you the new but noble art of cold-calling clients to sell money market funds, stocks, and bonds. Our analysts put together these financial packages, and you get out there and sell them.”
He added that interrupting busy people with a sales pitch was no walk in the park. In fact, he suggested that if I was any good, I had a fighting chance of becoming, in a very short time, the least popular person in Pennsylvania. “But if you’re good,” he told me, “the money’s good.”

…

It was happening right now in those last days of June 2007. Maybe it was the Bear Stearns hedge funds, maybe the rumors about Merrill’s unsold CDOs, maybe the avalanche of investors piling into Jeremiah’s short index trades. But whatever it was, the commercial paper market, the lifeblood of us all, was suddenly contracting. There was a clear and definite reluctance on the part of banks and money market funds to lend to us speculators. Both Mike and Larry would have chuckled sarcastically, No! How could anything like that possibly have happened?
The signs were barely discernible, but on June 30 there was another minor hand grenade landing on the floor. Someone found out almost one in four of all Countrywide’s subprime loans were delinquent—25 percent, up from 15 percent against the same period last year.

It took finance 20 years or so to catch up, but when it did, innovators realized you got more headlines jamming “junk” bonds into institutional portfolios than making a market in high-yield securities. You didn’t offer to buy a large block of a company’s shares, you ran a corporate “raid,” “hostile” if possible. George Soros did not try to explain that his selling of the British pound improved economic allocation for everyone; he gloried in the charge that he had attacked Britain and won.
The 1970s saw major innovations of great importance to investors. Money market funds, for example, got around the long-standing rules that limited interest rates investors could earn. No-load, low-fee index mutual funds offered tremendous value compared to alternatives for most investors. The fixed commissions that had been the entire reason Wall Street was created in the 1792 Buttonwood Agreement, disappeared in 1975, paving the way for the discount brokerage firms that would dominate the market and changing the way Wall Street did research.

…

Where Did the Money Come From?
How did a few nerdy quants incite this riot? Let’s answer that question by asking another one. Who paid for all this growth? Did people suddenly start saving more, or taking money that had been other places and giving it to Wall Street? No and no. Global savings rates declined. People changed the types of financial institutions that held their money, such as from bank accounts to money market funds, or using mutual funds instead of whole life insurance for retirement planning, but they didn’t contribute significantly more money in total. The reason it seemed that more money came to Wall Street is that most private retirement plans changed from defined-benefit plans where the employer manages the retirement account to defined-contribution plans where the employee does. But Wall Street held the funds under both systems.

At the time of writing (April 2008), it is still trading at one third of the level Glassman and Hassett predicted.
The performance of the American stock market is perhaps best measured by comparing the total returns on stocks, assuming the reinvestment of all dividends, with the total returns on other financial assets such as government bonds and commercial or Treasury bills, the last of which can be taken as a proxy for any short-term instrument like a money market fund or a demand deposit at a bank. The start date, 1964, is the year of the author’s birth. It will immediately be apparent that if my parents had been able to invest even a modest sum in the US stock market at that date, and to continue reinvesting the dividends they earned each year, they would have been able to increase their initial investment by a factor of nearly seventy by 2007. For example, $10,000 would have become $700,000.

…

In the late 1970s, this sleepy sector was hit first by double-digit inflation - which reached 13.3 per cent in 1979 - and then by sharply rising interest rates as the newly appointed Federal Reserve Chairman Paul Volcker sought to break the wage-price spiral by slowing monetary growth. This double punch was lethal. The S&Ls were simultaneously losing money on long-term fixed-rate mortgages, because of inflation, and haemorrhaging deposits to higher-interest money market funds. The response in Washington from both the Carter and Reagan administrations was to try to salvage the entire sector with tax breaks and deregulation,ap in the belief that market forces could solve the problem.37 When the new legislation was passed, President Reagan declared: ‘All in all, I think we hit the jackpot.’38 Some people certainly did.
On the one hand, S&Ls could now invest in whatever they liked, not just long-term mortgages.

By now you probably want to know where to send your check. Save
your stamp. Blake stopped accepting client funds five years ago. He
has made only two exceptions since then; both times for close friends.
Blake is a mutual fund timer. Generally speaking, mutual fund timers
attempt to enhance the yield return on a stock or bond fund by
switching into a money market fund whenever conditions are deemed
unfavorable. In Blake’s case, he doesn’t merely switch back and forth
between a single mutual fund and a money market fund but also makes
the additional decision of which sector in a group of sector funds
provides the best opportunity on a given day. Blake uses purely technical models to generate signals for the optimum daily investment
strategy. His holding period tends to be very short, typically ranging
between one and four days. By using this methodology, Blake has been
able to show consistent monthly profits even in those months when the
funds in which he invested registered significant declines.

(Earlier in the year they had saved Bear Stearns, another troubled investment bank, by arranging a takeover by JPMorgan Chase.) When Lehman declared bankruptcy, leaving all of its creditors high and dry, the global financial system essentially seized up. A Treasury official described the cascade of panic to The New Yorker: “Lehman Brothers begat the Reserve collapse [a money-market fund], which begat the money-market run, so the money-market funds wouldn’t buy commercial paper [short-term loans to corporations like GE]. The commercial-paper market was on the brink of destruction. At this point, the banking system stops functioning.”12
Sensible people started talking about surviving by raising goats in the backyard. (Okay, that was me.) My college roommate, who has gone on to become the CEO of a major company, admitted later that he had hidden $10,000 in a cowboy boot in his closet.

Some of the above-ground effects arise within particular businesses, as management diverts its cash flow away from profitable investment and into martini lunches, fees for celebrity consultants, vast and monumental corporate headquarters, objets d’art for the president’s office, prestige advertising and charity, season tickets to sports events, country club memberships, and trips in the company jet to management conferences in Hawaii in January. Labor gets pensions and fringes, medical plans and stock plans, and executives get perks and awards for statesmanship rather than denunciations for excess profits.
Somewhat lower in prestige but still above ground is the balmy culture of tax shelters and avoidance devices and the sudden mushrooming of money market funds, which waste much of our most valuable financial talent in a superfluous intermediation of money. The canny legions of lawyers, accountants, and other financial finaglers are of considerable value to their clients, but in this field they contribute little to the long-run growth of the economy. A tumescence within the corporate structure, these ancillary departments grow in direct proportion not only to rising taxes, but also to the rise of regulation and bureaucracy in Washington.

That is a pretty impressive change in behavior produced by a supposedly irrelevant factor.
Madrian and Shea aptly called the resulting paper “The Power of Suggestion,” and their analyses reveal that the power of default options can have a downside. Any company that adopts automatic enrollment has to choose a default saving rate and a default investment portfolio. Their company had adopted a 3% saving rate as the default, and the money went into a money market fund, an option with little risk but also a very low rate of return, meaning that savings would be slow to accumulate. The government influenced both of these choices. The company had no choice about the selection of the money market account as the default investment because, at that time, it was the only option approved for such use by the U.S. Department of Labor. Since then, the Department of Labor has approved a host of what are called “qualified default investment alternatives,” and most plans now choose a fund that mixes stocks and bonds and gradually reduces the percentage in stocks as the worker approaches retirement.

…

Call it an unintentional default.
Both of these default choices—the money market investment option and the 3% saving rate—were not intended by the employer to be either suggestions or advice. Instead, these options were picked to minimize the chance that the company would be sued. But employees seemed to treat the default options as suggestions. Most ended up saving 3% and investing in a money market fund.
By comparing the choices of people who joined before automatic enrollment with those who came after, Madrian and Shea were able to show that some employees would have selected a higher saving rate if left to their own devices. In particular, many employees had heretofore picked a 6% savings rate—the rate at which the employer stopped matching contributions. After automatic enrollment came in, there were fewer people choosing 6% and more choosing 3%.

Thus, blockchain can do for the movement of value what the standard shipping container did for the movement of goods: dramatically lower cost, improve speed, reduce friction, and boost economic growth and prosperity.
3. Storing Value: Financial institutions are the repositories of value for people, institutions, and governments. For the average Joe, a bank stores value in a safety deposit box, a savings account, or a checking account. For large institutions that want ready liquidity with the guarantee of a small return on their cash equivalents, so-called risk-free investments such as money market funds or Treasury bills will do the trick. Individuals need not rely on banks as the primary stores of value or as providers of savings and checking accounts, and institutions will have a more efficient mechanism to buy and hold risk-free financial assets.
4. Lending Value: From household mortgages to T-bills, financial institutions facilitate the issuance of credit such as credit card debt, mortgages, corporate bonds, municipal bonds, government bonds, and asset-backed securities.

This occurred in complex legislation and rulemaking, and the details are not important to this book. This deregulation was harmful—it was critical to making S&Ls the ideal Ponzi scheme—but it was also essential. Unless the nation was prepared to extend interest rate controls to money market funds (which was impossible politically and would have been very bad economics), S&Ls and banks had to be allowed to pay competitive rates of interest, or else depositors would have removed most of their deposits and transferred them to money market funds that were paying three times the interest rate permitted under Reg Q. The administration, not Pratt, led the charge to repeal Reg Q.
Another act that critics often blame incorrectly for the resulting S&L debacle was Congress’s raising the deposit insurance limit from $40,000 to $100,000.

Little ink is wasted on investments that pick-up small profits on mundane price discrepancies. Yet, that is where most of the hedge fund industry’s bread is made and buttered.
Emerging from the Ashes
The hedge fund failures referenced previously were nothing compared with the financial crisis that the world experienced (and is arguably still experiencing) from 2007 to 2009. Although all investment vehicles have been vilified by the press, investment banks, housing lenders, money market funds, and insurers experienced the largest losses. In 2007, hedge funds ended the year up 10 percent. By the end of the debacle of 2008, they were down 21 percent while the S&P 500 Index was down almost twice as much to 37 percent (see Table 2.1).
Table 2.1 Comparable Performance: HFRI Fund of Funds vs. S&P 500 TR
Source: Data provided by PerTrac, Hedge Fund Research, Inc.
One hedge fund manager, John Paulson, was even able to profit from this mess.

Who can spot the air, an
Reinventing the Commons
| 67
aquifer, or the social trust that underlies financial markets? The more
relevant reason is our own blindness: the only economic matter we
notice is the kind that glistens with dollar signs. We ignore common
wealth because it lacks price tags and property rights.
I first began to appreciate common wealth when Working
Assets launched its socially screened money market fund. My job was
to write advertisements that spurred people to send us large sums of
money. Our promise was that we’d make this money grow, without
investing in really bad companies, and send it back—including the
growth, but minus our management fee—any time the investor
requested. It struck me as quite remarkable that people who didn’t
know us from a hole in the wall would send us substantial portions
of their savings.

They
recognized the high administrative costs associated with the existing system of defined contribution pensions in the United States, as well as the costs of
privatized Social Security systems in other countries. In order to reduce the costs of a privatized system, they proposed having a single centralized system which would pool workers’ savings from all over the country. Their proposal
called for having a limited number of investments options (e.g. a stock index fund, a bond index fund, a money market fund, and possibly one or two other
options) and limited opportunities to switch between funds.
According to the Bush commission’s estimates, the administrative costs of
this bare-bones system would be approximately 5 percent of the money paid
into the system. While this is still very expensive compared to the 0.5 percent in administrative fees charged by Social Security, it is far less than the 15-20
percent in fees charged by financial firms for operating private sector defined contribution pensions in the United States, or that financial firms charge to operate privatized Social Security accounts in other countries.

This was the moment in which a deregulatory process which could have taken years or decades was packed into a single act: in effect (and for the purposes of simplification), all the historic barriers, separations, and rules demarcating different areas of banking and finance and participation in the stock market were simultaneously abolished. I have used the word “bank” throughout this book to simplify the point, but in reality many modern financial intermediaries—the bodies standing in between the people who want to borrow money and the people who want to lend it—aren’t, strictly speaking, banks at all. There are home loan specialists, credit unions, private equity funds, securitization specialists, money market funds, hedge funds, and insurance companies, all of them differently regulated and not a few of them functioning as separate parts of the same institution. The institutions which make up this world of nonbank banks are sometimes referred to collectively as the “shadow banking system,” and insofar as it has a capital, that capital is the City of London.
Taken together, what this led to was the City’s increasing dominance of British economic life—and Wall Street’s equivalent domination in the United States.

In March of 2008, the Federal Reserve facilitated the takeover of Bear Stearns by JP Morgan. In September, after Lehman Brothers was allowed to fail and financial markets began to panic, the Fed and the Treasury Department began bailing with both hands. They put together an emergency package for AIG, an unregulated hedge fund grafted onto an insurance company; they took over Fannie Mae and Freddie Mac, the mortgage companies; they rode to the rescue of the nation’s money-market funds and organized the distress-takeover of the huge Wachovia bank. And then, having warmed themselves up with these exercises, they went to Congress and asked for that notorious intervention known as the Troubled Asset Relief Program (TARP): $700 billion as a generalized rescue fund for the nation’s banks, to be administered however the former Goldman Sachs chairman, Treasury Secretary Hank Paulson, saw fit.

The Swiss portfolio bond establishes a legal relationship between the insurance company and the client by use of a contract called a policy or bond.
The client decides the type of investments he or she is interested in, and the
insurance investment managers provide their expertise and advice to help
maximize those decisions. Thereafter, the portfolio is professionally managed, although you may direct investments, including the purchase shares of
stock, bonds, unit trusts, cash deposits, mutual funds, money market funds,
and so on. In addition, any investment where value can be established, as
can be accomplished in a liquid market (i.e., one where the security or asset
can readily be traded on an exchange), can also be incorporated into the
portfolio. Other assets can be valued through an appraisal by a reputable, certified appraiser or certified public accountant. Real estate, art, and
stock in a closely held company are a few examples.

"Any system which gives so much power and so much discretion to a few men that
[their] mistakes—excusable or not—can have such far-reaching effects is a bad system," he wrote (Friedman 1982 [1962], 50). Among many choices, including the gold standard, Friedman has favored a
"monetary rule" whereby the money supply (usually M2) is increased at a steady rate equal to the long-term growth rate of the economy.
One of the problems with Friedman's monetary rule is how to define the money supply. Is it Ml, M2, M3, or what? It is hard to measure in an age of money market funds, short-term CDs, overnight loans, and Eurodollars. Notwithstanding theoretical support for a monetary rule, central bankers have largely focused on "inflation targeting,"
that is, price stabilization and interest rate manipulation, as a preferable method.
The Shadow of Marx and the Creative Destruction of Socialism
The Herculean efforts of Milton Friedman, Friedrich Hayek, and other libertarian economists were not the only reason neoclassical economics has made a stupendous comeback.

Andrew Lo of MIT and his two coauthors contend that new streams of financial data—aggregated, properly encrypted, and then analyzed—could give strong clues to hidden risk bombs in the system, like the institutions that touched off the crisis in the fall of 2008, Lehman Brothers and the American International Group. Such data, the authors argue, could “have played a critical role in providing regulators and investors with advance notice of AIG’s unusually concentrated position in credit-default swaps, as well as the exposure of money market funds to Lehman bonds.”
This is big data as a financial microscope. The goal is to see the inner workings of markets in illuminating detail to inform understanding and guide action. So Berner is a big-data proponent, but not without qualification. He is skeptical of the uncompromising data-ists who celebrate correlation as plenty good enough without theory, without a model of how the world works.

This is bad news, particularly as your bank and government default may well happen at the same time as other things in your life are being negatively affected by the same economic factors; you may have lost your job, your house may decline in value, and so on. It is exactly in that circumstance that you want the diversification of investments and assets that the rational portfolio provides.
A way to address the potential lack of security of your cash in the bank is to buy securities like AAA/AA government bonds or other investment securities that closely resemble cash (such as money market funds, etc.). Importantly, securities like these still belong to you even in the case of a bank default, and while the process of moving that security to another financial institution could be cumbersome, you are no longer a creditor to a failed bank, which gives you far greater security in a calamity.
While investments like stocks and bonds held in custody at a bank still belong to you if the bank goes bust, you should be careful about holding too many assets at risky banks.

Here’s how the great Arthur Laffer explained it to the late Robert L. Bartley (legendary editor of the Wall Street Journal’s editorial page) in the 1970s. As Bartley recalled in his wonderful book The Seven Fat Years (1992),
Laffer would draw a tiny black box in the corner of a sheet of paper. “This is M-1,” currency and checking deposits. A bigger box was M-2, including savings deposits. Still bigger boxes included money-market funds, then various credit lines. Finally, the whole page was filled with a box called “unutilized trade credit”—that is, whatever you can charge on the credit cards in your pocket. Do you really think, he asked, this little black box controls all of the others. The money supply, he insisted, was “demand determined.”6
Taking this further, Bartley recalled the wisdom of 1999 Nobel Laureate Robert Mundell, who also regularly attended the gatherings with Bartley, Laffer, and other supply-side thinkers.

Wasn’t the stress in money markets reported in the financial press?
It was reported. It was all public information, but the point is that no one thought it mattered. Even more than three years later, we are sitting
here, and you are saying, “Really, money markets broke down in August 2007? Really?”
Well, I have to admit, when I think of money markets breaking down in the financial crises, I think of the breaking of the buck by some
money market funds in the aftermath of the failure of Lehman Brothers and the subsequent freezing up of the commercial paper
market. But these events occurred more than a year later in September 2008.
That’s my point. No one seemed to think it was important. The S&P actually went on to make new highs in the next two months.
But you made your transition from bullish positions to bearish in August 2007?
Yes, I turned bearish when money market liquidity dried up in August 2007.

…

Anyway, when this crack appeared in the market, I knew I didn’t want to have equity exposure. So during the next six weeks, we liquidated the
entire $9 billion of exposure. The strategy was shut, and the money was sent back to investors. We watched the markets very carefully, and in
early 2008, I transferred a vast proportion of the firm’s money into two-year treasury notes. I got rid of all the money market funds. I put all the
traders into a wind down of counterparty exposure. We dumped outright exposure to every bank possible and went maximum long fixed
income. The systematic trend-following strategy was consistently moving into a similar position. It started reversing from long to short in
equities and commodities and going hugely long in fixed income. Again, it was all the same trade, wasn’t it?

International relations scholars had overlooked this, she said, because their key problem was the prevalence of violent conflict and war between states (Strange 1998a: 41).
45 The terms “M3” and “M4” refer to measures of an economy’s money supply and are used by central banks for the purpose of directing monetary policy and trying to control inflation. There are five categories in all: M0 and M1 (also called narrow money) include coins and notes in circulation and other money equivalents that can be converted into cash with ease; M2 includes M1 and short-term time deposits (i.e., bank deposits that can only be withdrawn with notice or, if immediately, with a penalty) in banks and 24-hour money market funds; M3 includes M2 plus longer term time deposits and money market funds with more than 24-hour maturity. M4 includes M3 plus other deposits. The exact definitions of the measures depend on local conditions (McLealy et al. 2014: 23). See http://lexicon.ft.com/Term?term=m0,-m1,-m2,-m3,-m4.
46 Source: Chinese Foreign State Administration of Foreign Exchange, see http://www.safe.gov.cn/wps/portal/english/Data/Payments.
47 Source: Bureau of Economic Analysis, see http://www.bea.gov/iTable/index_ita.cfm.
48 Source: Securities Industry and Financial Markets Association, see http://www.sifma.org/research/statistics.aspx.
49 She subsequently criticized Fukuyama’s Trust (Fukuyama 1995) because, even in distinguishing between high-and low-trust societies, he failed to address the problem of trust in the value and stability of money, which, she argued, “causes most conflict at every level of social interaction” (Strange 1998b: 7).
50 Drawee: The person who is requested to pay, e.g., the drawee could be the bank, ordered by one of its depositors, the drawer, to pay a sum of money to a third party.

(For more on inflation-protected TIPS, see the commentary on Chapter 2.)
FIGURE 4-1 The Wide World of Bonds
Sources: Bankrate.com, Bloomberg, Lehman Brothers, Merrill Lynch, Morningstar, www.savingsbonds.gov
Notes: (D): purchased directly. (F): purchased through a mutual fund. “Ease of sale before maturity” indicates how readily you can sell at a fair price before maturity date; mutual funds typically offer better ease of sale than individual bonds. Money-market funds are Federally insured up to $100,000 if purchased at an FDIC-member bank, but otherwise carry only an implicit pledge not to lose value. Federal income tax on savings bonds is deferred until redemption or maturity. Municipal bonds are generally exempt from state income tax only in the state where they were issued.
Savings bonds, unlike Treasuries, are not marketable; you cannot sell them to another investor, and you’ll forfeit three months of interest if you redeem them in less than five years.

And on and on; a cascading waterfall of cash thrown off by debtors each month as they sat down to pay their credit card bills, home mortgages, car loans, and student loans; the cash bucket—minded by investment bankers as trustees—filling up and then spilling into different pools to pay different investors (maybe even some of the same investors who were writing the checks). After all, asset-backed securities were then widely held by mutual funds, money market funds, and pension funds, which in turn were invested in by ordinary savers.
The principle of securitization has remained the same since the eighteenth century. If you pool enough risky debt together, and the risk of default is sufficiently uncorrelated, then you can structure part of the resulting cash flow into a safer security. An asset-backed security also has the extra benefit of a claim on an underlying real asset.

Remarkably, many employees still do not think these risks apply to their
own employer. There are three problems here. First, employees do not
seem to understand the risk-and-return proﬁle of company stock. When
the Boston Research Group surveyed 401(k) participants in 2002, it found
that despite a high level of awareness of the Enron experience, half of the
respondents thought that their own company stock carried the same or
less risk than a money market fund. Another recent survey found that only
a third of the respondents who owned company stock realized that it is
riskier than a “diversiﬁed fund with many different stocks.”9
Second, plan participants tend to extrapolate past performance into the
future. Employees of companies whose stock has been performing well
over the previous ten years tend to invest much more in company stock
NAÏVE INVESTING
than employees at ﬁrms that were performing poorly.